I recently read “Dead Companies Walking,” a book about short selling by hedge fund manager Scott Fearon. These are essentially uncharted waters for me: I’ve only shorted one stock in my life. It was a few years ago, and I made a little bit of money. The truth is I was lucky more than anything else; if I was still short the stock, I’d be sitting on a sizable loss.
I may give it another go. This is undoubtedly influenced by my inability to find stocks to buy on the long side. It seems reasonable that the breakneck pace of the Standard & Poor's 500 over the past five-plus years may have created some compelling opportunities on the short side.
At this point, I’m still focused on the basic criteria of a good short: what should I look for (or screen for) to find potential short candidates?
My first thought is to target formerly attractive businesses that have seen their day in the sun.
Companies that are consistently profitable usually trade off a multiple of earnings or free cash flow. That number is usually much higher than the net asset value of the business. If we can find good businesses on their way to becoming crummy businesses, they are likely valued against an unsustainable level of earnings; these would be good short candidates.
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- AMZN 15-Year Financial Data
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Outside of recognizing the change in business quality (which is easier said than done), the other issue is timing. The answer is small position sizes – small enough to handle years of negative price action. Short seller Jim Chanos (Trades, Portfolio) does not like any position to be above 5% of his portfolio, with an average size of 2%. That seems like a reasonable starting point.
A focus on business quality forces you to think long term. The problem I see with valuation-based shorts – particularly on attractive underlying businesses with sustainable competitive advantages – is that time is your enemy. Even if you start with a seemingly absurd valuation, compounding can work wonders in a few years. Charlie Munger (Trades, Portfolio) captured this idea perfectly:
“Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result.”
Amazon (AMZN) is a great example of a valuation-based short ending in disaster.
Ten years ago the company’s market cap was roughly $20 billion. Based on fiscal 2007 earnings of $476 million, the forward price-earnings (P/E) was north of 40x earnings. That’s the kind of P/E multiple that can attract short sellers. The outcome? Over the ensuing decade, the stock has been a ten-bagger (and then some). As an interesting side note, the biggest driver has Amazon Web Services (AWS) – a business that barely existed in 2007.
If you’re making a statement about the long-term value of the business (as opposed to a short-term guess about changes in the valuation or stock price), betting against someone like Jeff Bezos seems like a really bad idea – almost regardless of valuation (particularly when the company is small). It’s probably best to search for greener pastures elsewhere.
The next thought I have about short selling also applies to Amazon: Try to avoid companies in the spotlight. As an individual investor, why bother trying to outsmart dozens of analysts and thousands of investors on the future of Tesla (TSLA)? Why not fish in less crowded ponds?
Everybody reading this article probably has an opinion about Amazon and Tesla; we feel the need to have an opinion about them simply because they are familiar to us. It's critical to remember that knowing about the business and actually having a unique insight are two very different things.
I’ll end with an idea from Fearon’s book that I find interesting: Wait for the stock of a potential target to decline before taking a position. While I’m less concerned about short-term volatility or any type of momentum-based trading, there’s an interesting corollary to that point: Many companies pay their employees with stock or allow them to invest sizable sums in the company through their 401(k). It seems reasonable that a precipitous fall in the stock price, along with negative headlines, could have a material impact on morale. The falling stock price could potentially perpetuate the downfall of a company that’s hanging on the ropes. That’s especially true when the culture has created an unhealthy focus on the stock price (consider the example of Enron, where the daily stock price was displayed on the elevators and in the lobby). If the best people start heading for the exits, the demise of the company won’t be far behind.
In a recent interview with Young Investors Society, Pat Dorsey said the following:
“Short selling is incredibly hard. The few good short sellers I’ve met never, ever, ever short because of valuation. They short because a business is fraudulent or fundamentally flawed.”
That’s a good way of summing up my takeaway from this exercise.
Here’s the perfect storm, as I see it: first, a company where a formerly attractive legacy business is on the decline; second, the management team refuses to accept reality and / or doesn’t know what to do about it; and third, the valuation is still reflects the economics of the legacy business. The icing on the cake would be overly aggressive accounting – or even a fraudulent company.
These conditions obviously limit the number of potential targets to a small group; if your goal is to make money on the short side (as opposed to hedging market exposure or reducing volatility), my assumption would be it is just as difficult as finding a truly great long position.
This still doesn’t address the timing issue. Just like on the long side, positions can move against you – potentially for years. The difference, of course, is that the magnitude of the move is not capped when you’re short (you can lose more than 100% of the initial “investment”). If the market moves against you, the short becomes a larger percentage of your portfolio (as opposed to a smaller percentage if you were long). Your level of conviction needs to increase just as its being put into question (people usually question their thesis once the account statement is showing large red numbers). As Mohnish Pabrai once said, “the maximum upside is a double and the maximum downside is bankruptcy.” This materially increases the difficulty of short selling.
“You’ll see way more stocks that are dramatically overvalued than dramatically undervalued. It’s common for promoters to cause a stock to become valued at five to 10 times its true value but rare to find a stock trading at 10% to 20% of its true value. So you might think short selling is easy, but it’s not. Often stocks are overvalued because there is a promoter or a crook behind it. They can often bootstrap into value by using the shares of their overvalued stock. For example, it’s worth $10 and is trading at $100, they might be able to build value to $50. Then, Wall Street says, 'Hey! Look at all that value creation!' and the game goes on. You could run out of money before the promoter runs out of ideas. Charlie and I have agreed on around 100 stocks over the years that we thought were shorts or promotions. Had we acted on them, we might have lost all of our money, even though we were right just about every time. I had a harrowing experience shorting a stock in 1954. I wouldn’t have been wrong over 10 years, but I was very wrong after 10 weeks, which was the relevant period. My net worth was evaporating.”
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About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.