Value investing is all about identifying mispriced assets. Usually this entails finding underpriced or unfairly maligned names that will, in the fullness of time, be restored to honor within the market. Unfortunately, finding such opportunities has gotten increasingly difficult thanks to the explosion in readily available, real-time information. Mispricing certainly does still happen, but it does so less frequently and with less reliability than in ages past.
How, then, can an investor obtain alpha, i.e., risk-adjusted market-beating returns? One option may lie on the short side.
Opportunity in betting against the echo-chamber
There can be little doubt that the various accretions and appendages of the market, such as the financial media, act in a way that is overwhelmingly bullish, both in general and in regard to individual securities. Jim Chanos (Trades, Portfolio), the legendary short-seller at the helm of Kykinos Associates, has reflected on this psychological aspect of the short side. Because Wall Street analysts and commentators act as an echo-chamber of bullish positivity, it has the potential to drown out sensible criticism:
“If you think about Wall Street - it’s a giant positive reinforcement machine. I come in every morning, flip on my Blackberry, check Bloomberg - and of the 100 short ideas that we have in our global fund, I can pretty much confidently predict that there are going to be 20% to 25% every day that are going to have some sort of commentary about it: research reports, analyst buy recommendations reaffirmed, estimates raised, CEO is on Bloomberg or CNBC - and generally it’s noise, there’s not that much informational content in that. But its positive noise - it's why you should be investing in company A,B,C, or that they’re a takeover target, or that they have some new product. And most people don’t even notice that, because they’re in the business of going long securities. It’s like the music that plays in the background of the investment world.”
To beat the herd, one must think differently than the herd. That is a classic lesson of market psychology – and a core tenet of value investing. So when the market herd is persistently bullish, the contrarian thing may be to turn bearish.
Myth of short alpha in long-short hedge fund strategies
The sort of short-side alpha described by Chanos is very different from how it is usually treated on Wall Street. Indeed, when one considers the commonplace long-short hedge fund strategy, it quickly becomes apparent that it is not designed to deliver the sort of analytical alpha that has helped Kykinos outperform the stock market. According to an article published by Eureka Hedge, there is little empirical evidence to support the idea that long-short fund managers deliver short-side alpha through their strategies:
“Based on the evidence, short side alpha seems to be quite elusive or, at the very least, very difficult to measure. Perhaps institutional investors have been focusing on the wrong issue and perhaps they have been marketed an unattainable ideal. Short side alpha sounds great, but is it really attainable? Maybe the principal focus should be on a manager's ability to produce stable and attractive returns while being able to skillfully navigate through periods of extreme volatility. What's more, investors may want to home in on the liquidity, capacity and scalability of a strategy. These topics certainly seem more tangible than short side alpha and, in the long run, are probably more important to long-term capital preservation and appreciation.”
With the idea of short alpha so constrained and nebulous in this context, it is little wonder that few fund managers report it. Indeed, most would probably have difficulty isolating it for themselves, let alone their clients.
In pursuit of short alpha
Clearly, the most common use of short selling, supporting long-short strategies, lacks much rigor to bolster it. On the other hand, short-selling in the Chanos vein – seeking out individual securities that are mispriced on the upside – is more defensible and comprehensible. It is simply a slightly different application of the same analytical tools that inform a value investor’s long position decisions.
Short strategies clearly have utility. Moreover, in this world of persistent bullishness amid ever-greater publicly available financial and operational information, short-side analysis may actually be the most effective value-oriented strategy available in many instances.
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