Short-sellers are often solitary players. It may be a matter of culture. After all, institutions, mutual funds and their ilk have bureaucratic controls, and clients who can get nervous about a strategy that goes against the grain. That conservative psychology is one factor (of many) that tends to push such investment managers to favor long-only, or nearly long-only, strategies. Even most hedge funds, which often try to portray themselves as mavericks and go-getters, tend to be wary of getting too deep into the short side of trades.
Thus, while there definitely are some notable funds playing the short-selling game, it is often strong-willed individuals or very small teams that make their names in these more treacherous, and often psychologically taxing, waters. One of the greats of the modern short game is Marc Cohodes.
We discussed Cohodes’ methods for limiting risk in a shorting opportunity in a previous research note. Today, we delve further into Cohodes’ approach, this time examining his methods and rules for identifying a perfect short target.
Despite all the regulations and enforcement agencies now involved in securities markets, many companies have still found ways to misstate their financial and operational realities. Cohodes’ track record is a living testament to the market’s exploitable inefficiencies.
Frauds make the best shorts
Cohodes’ most recent target (one ought to call it a target in progress) is MiMedx (MDXG, Financial), “a biopharmaceutical company developing, manufacturing and marketing regenerative biologics utilizing human placental allografts for multiple sectors of healthcare.” MiMedx offers a perfect example of the ideal short target according to the Cohodes playbook.
Cohodes has been embroiled in a relentless battle with the company’s management, which has sought to silence him through legal and political means. The fight has gone on for years, but Cohodes now appears to be on the cusp of victory. Both the CEO and COO of MiMedx resigned this summer under a dark cloud, and Cohodes’ accusation of fraudulent business maneuvers, including channel stuffing, appears at last to be starting to stick.
MiMedx is a case of Cohodes’ favorite kind of short opportunity: outright frauds. As he puts it himself: “I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets.”
Cohodes has been calling MiMedx a fraud for some time, but it has taken a long time for the market to come around to this view on MiMedx, just as it has taken the government regulatory and investigative agencies ages to take a look under the hood.
Vindication has come at last, but it is an excellent case study of the psychological travails the lonely short-seller must endure before being proven right.
Multiple shots on goal
Some investors will take short positions on the basis of a target company’s valuation. Its stock may be trading wildly out of alignment with fundamentals, or may fail to reflect material risks or other issues. Cohodes does not agree with this thinking, especially when it comes to stocks being driven upward or buoyed by irrational exuberance. Even if the stock is overvalued, the market may not agree for a long time. The stock might well continue to move up for a spell.
While taking extensive precautions and maintaining a healthy margin of safety can keep a short-seller’s position from blowing up, waiting for the jaguar to come out of the tree can prove a tedious wait. That can mean leaving dead money in a position when it could be deployed elsewhere more effectively until the narrative finally starts to shift meaningfully against the target stock. This tends to be Cohodes’ approach. He does not short on the basis of a stock’s overvaluation alone. Rather, he looks for companies with multiple observable weaknesses, any of which could trigger the desired downward correction:
"I prefer situations in which I can have five shooters on the target rather than one. For example, I think I can win on a bubble, on fraud, on lack of reserves, on the macroeconomics, on money laundering. There's a zillion ways I can win."
Such companies, when they can be found, provide multiple “shots on goal,” so there is a range of opportunities and factors involved that could crush the overvalued stock back down to earth. This means a thesis has sufficient breadth to account for a range of failings and does not hinge on a single problem. A company may be able to fix one problem, even a grave one. But with a multitude of issues, the target company is unlikely to be able to get out intact.
Fixation on shorts is a sign of opportunity
One clear sign Cohodes cites as an indicator of a potential shorting opportunity is if management is fixated on short-sellers. The best way to blow up shorts is to prove their thesis wrong. The focus has to be on execution. If the focus is on how “unfairly” shorts are treating their company, then management may have something to hide: "Any company with a management team that focuses on, mentions, is bothered by, or attempts to squeeze short sellers, is almost definitely a short."
Capable shorts are relentless by nature and will ultimately ferret out the dirt on a target company, if any exists. A company or management team obsessing about short-sellers has something to hide. It is a clear tell that the company is more concerned with perceptions of its operations and growth than with actually executing operationally or delivering on growth.
The lonely road
Shorting can be extremely profitable. But it is not easy. It requires tremendous discipline and demands actual research. So many players in the market, whether individual investors or professional money managers, parrot the reports of analysts and follow the stream. And that works most of the time. But it serves little purpose for the short side.
If you want to be a short-seller, prepare to do a lot of independent research. It is not easy, but it pays off.
Disclosure: No positions.
