High-Conviction Short Sales: Empathy for the Bull
Short sellers face what may be the most treacherous background in market history.
Dovish US Federal Reserve policy has not only boosted equity multiples, but has also led to cheap credit and a boom in mergers and acquisitions. Inefficiencies on the short side are quickly resolved through thousands of long/short funds desperately trying to justify their 2 and 20. Prime brokers have introduced negative rebates on borrowed securities as banks search for new sources of revenue.
In some cases, a short seller can pay 100% or more in annualized borrow for the honor of being exposed to unlimited upside risk. Why bother?
In Fooling Some of the People All of the Time, A Long Short, David Einhorn writes “Selling short individual names offers two ways to win — either the market declines or the company-specific analysis proves correct.” A broad market decline will help your short book, but it is impossible to predict. It is more prudent to focus on the latter possibility: profiting from the short sale of single stocks.
The best short sellers share one key personality trait: empathy, or the ability to put themselves in their counterparty’s shoes. The credo of a short should be Charlie Munger’s famous quote: “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do.”
Before initiating any short position, make sure you know the answer to the following three questions:
What are the bulls playing for and what expectations are embedded in the stock?
As a short seller, you win when the bull’s theory falls apart and they reach for the red “Sell” button.
To know what will break their theory, you need to follow Munger’s advice and know their argument better than they do. The informational asymmetry of shorting is an advantage here. Most stocks are well-covered by the sell side, which makes it easy to get current on the bull vs. bear debate and the relevant catalysts. As Jim Chanos noted, “If you are long a stock, knowing what the bear case is takes work. . . . If you are a fundamental short seller you have no problem finding out what the bull case is.”
Reverse engineering a discounted cash-flow model will yield the cleanest assessment of the implied expectations for a given stock. For a shorthand guide, sell-side consensus should be close enough, with the added knowledge that lazy investors tend to outsource their due diligence to Wall Street and then anchor their forecasts accordingly. Revisions of earnings estimates tend to drive share prices, and Street estimates are almost always too optimistic.
Common errors to look for in sell-side models include unrealistic revenue growth forecasts or mis-modeling operating leverage. This typically manifests itself by hardcoded margin assumptions rather than a thoughtful analysis of fixed vs. variable cost drivers.
What valuation metrics are the bulls focused on? Is it earnings growth, free cash-flow generation, book value, or something else?
Investors in different sectors focus on different metrics, and you need to know which one is most important to use.
Poor practices include shorting a biotech stock because it’s overvalued on price to book, shorting a software company because it has negative trailing earnings, or shorting an airline because the industry has mediocre returns on capital.
Management teams often influence their investor base, conditioning it to focus on a particular metric. Some investors focus on earnings-per-share growth over free cash-flow generation — think airlines or cruise ships — so any short theory based on capital intensity is fruitless.
Some investors (rightfully) focus on the inverse — free cash-flow generation rather than earnings growth — so shorting a stock just because the price-earnings (P/E) ratio is high will lead you down a long road of losses.
Ask a bear who has lost money shorting Amazon over the years because they focused on the firm’s anemic earnings or lumpy margin progression. Jeff Bezos has conditioned his shareholders to focus on one metric: absolute dollar free cash-flow per share, and shareholders have been rewarded with a higher stock price as he delivered.
Does the bulls’ time horizon match up with yours and are there catalysts to re-rate the stock lower?
The average institutional investor focuses on the outlook for the next 12 to 18 months, but there are exceptions.
For example, many energy stocks currently trade at a forward P/E ratio in the triple digits yet are still well-bid. Energy investors aren’t buying these stocks expecting they will generate prodigious cash in the next 12 to 18 months. Similar sectors like basic materials or industrials require a deeper level of peak-to-trough analysis. This can make it more difficult to have empathy for the bull, as their valuation is based on a “mid-cycle” earnings estimate and multiples of three to five years out.
Traditionally, cyclicals are difficult shorts requiring a string of consecutive earnings misses rather than one discrete catalyst to move shares lower. Also, you need to be correct on both your short entry at the top of the cycle and your short cover at the bottom. This is in contrast to less-strenuous terminal shorts in which you are simply waiting until the price hits zero.
Staying disciplined about mismatched time horizons can help with another breed of difficult shorts: the open-ended growth story where the payoff to bulls is many years away. These are colloquially known as “mañana stocks,” and tend to offer poor returns relative to the stress they cause. They often feature a cultish CEO and an investor base that will tolerate multiple quarterly earnings misses in the belief that there will be a grand payout in three to five years or beyond.
If the bulls’ theory is dependent upon what happens in the year 2020, it is incredibly difficult to disprove it in 2016, and remaining short a stock for that long is unwise given the market’s upward drift.
Focus on high-conviction situations in which you can cultivate empathy for the bull, lest your counterparty decides to cultivate sympathy for the bear.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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