by Amit Kumar
There is no formula to find the short ideas. The main characteristic they all have in common is that their business model is not going to produce the sales and earnings that are expected by the market. There will be a psychological disappointment, which will change the way investors view the company and create the revaluation downwards.
Q: Do you think it is harder to generate alpha on shorts than longs? Do you see greater interest in short ideas from your clients?
Our business is mainly to come up with short ideas for clients. Short sellers are not as highly rewarded as their long counterparts, while it is much more challenging to make money shorting. There is a tendency among hedge funds not to be short sellers; however, they have a charter to sell short. Most hedge funds think that they are better on the long side and they can make more money in longs. They concentrate on longs and hedge because they are trying to protect capital in a down market, but not too many funds short sell as their primary strategy.
Q: How important are channel checks and surveys, etc.?
If you are a short seller, by the nature of what you are trying to do, you are seeking the type of information that is not widely distributed and is not consensus thinking. Short ideas naturally need more discovery to reach conviction than longs because the information is harder to come by. It takes a lot more work and interviewing to find sources of information not available in the mainstream.
That said, we do not channel check. The most common example is calling stores to ask how they are selling during a time frame. We are not short-term oriented and we are looking for an investment thesis, so we do not find channel checking useful in the traditional sense.
Q: Do you think it is more important to identify short-term catalysts for shorts than longs?
We do not try to find short-term catalysts. We try to find medium-term investments where we expect the business model to not produce the sales and earnings that are expected. The catalyst is always a change in the investor psychology, which can be triggered by a number of factors such as sales miss, earning miss, accounting problems, competitive change.
Q: What is your process to find the short ideas?
There is no easy way to find shorts. It is like writing short stories. You always wonder where the next idea will come from or if there are any ideas around at all. Short ideas can come from screens, reading, talking to other investors, and we do all of the above. If it were so simple, everyone would do it successfully. That does not happen. We use all avenues to find ideas.
Q: Can you talk about one of your early ideas? Maybe Enron?
Enron was a great story. We were the only firm to publish a sell recommendation, and our research on Enron was quite extraordinary. Lots of people talked about their accounting, insider transactions, problems with the CFO [chief financial officer], but we demonstrated why Enron’s business model did not work. When you see accounting issues, it is generally because there are problems with the business and managers resort to earnings manipulation to cover up the issues. We never think of accounting issues as a reason to sell the stock per se. They are symptoms of larger problems and our job as analysts is to understand those problems. Accounting issues in themselves can be solved by good management if they have a good business model. But they cannot overcome fundamental business problems.
Q: Have you found it helpful to focus on any specific areas in the financial statements to spot accounting issues?
Not really. When there is a large difference between a company’s generally accepted accounting principles earnings and what the company claims as adjusted earnings—management of companies in any industry can use such techniques and the more promotional companies, with an agenda to advance their stock price, have an incentive to use more aggressive reporting techniques.
Q: Could you talk about an example where the stock did not perform as expected?
Back in the day, we were shorting AOL mainly on the accounting issues related to amortization of customer acquisition expense, specifically the length of time that they were amortizing. We got the issue right and the company was forced by the SEC [Securities and Exchange Commision] to eventually restate the accounting. However, we got the fundamentals of the business wrong, at least at that time. We hugely underestimated the size of the market, which was so much bigger with a long runway. This is the type of lesson that I was talking about. You can get the pieces right but the big picture wrong.
Q: So, when do you decide to hold or fold in such a case?
That is a tough one because we are not portfolio managers. We do fundamental research and our timing can be off. We do not like to close position where we get the fundamentals right just because the stock has gone against us. On the other hand, we have certainly witnessed some error if things go too far. We may have understood the company but not the investor sentiment. That is not a fundamental research error but an error in judging investor behavior.
We close positions when we think that a change in the nature of business alters our thesis or when our thesis is just not playing out or when there is no evidence that we are right. Sometimes our thesis will play out but it can take too long. We closed our position out of exhaustion in such a case. Overall, we try to produce investment quality ideas and not trading ideas.
Q: You recommend a short idea and it goes down 30 percent. You close the recommendation and it comes back up to where you recommended. Do you recommend them again?
Many times. For example, we successfully shorted F5 Networks (FFIV) on three occasions, twice recently. You can get a turnover in the investor base and new investors have not learned from the old investors. Old investors got discouraged by a story that now a whole new group of investors believes in.
Q: What changed about F5 Networks each time?
First time, the company missed numbers and the stock went down. We closed the position. New investors did not believe that the miss was related to fundamental reasons and the stock ran back up again. From our standpoint, the short thesis remained intact.
Q: How significant are macroeconomic indicators and cycles in your short analysis?
We only look at macro information in order to help us see the areas with overvalued names. We do not make macro predictions. It is not what we do and we do what we are good at.
Q: Have you recommended shorting commodities-linked stocks in the past?
We have not done too much in the commodities space. We have done more on the long side. We do not make a short call on economically sensitive stock because it is a call on the economic cycle and not a fundamental business call. It is not what we do.
Q: Have you recommended any value traps—stocks that seem cheap but have more potential downside?
We tend to be more long on the value traps. Sometimes, we recommend a stock that will go up but it does not. I call them value traps. Value traps are not good short candidates from our standpoint because the risk rewards are not favorable. Good management can do a lot for the company that has good revenue stream. It is hard to handicap.
Q: Have you looked at recent initial public offerings that trade at 10–20× sales, especially companies that made follow-on offerings?
No. We are not interested in such companies because their markets and business models are too open-ended and they are very hard to gauge.
Q: Do you stay away from stocks that engage high-profile investors or stocks with high short interest?
Yes. We only get involved where we can add value and do some differentiated research. We want to be original.
Off Wall Street Short Stories
Off Wall Street has contributed some of their past short recommendations for this book. I have tried my best to preserve the core analysis while presenting them in an abridged version in relevant parts of my framework throughout the book. The following case of Liquidity Services demonstrates where the threat of loss of key client contracts could impair a business model.
CASE STUDY:
LIQUIDITY SERVICES INC. (LQDT)
LQDT, bas
ed in Washington, DC, operates leading online auction marketplaces for surplus and salvage assets. It sells merchandise under consignment and profit-sharing arrangements, as well as for its own account. LQDT was predominantly a federal government contractor several years ago, with U.S. Department of Defense (DoD) contracts accounting for 77 percent of gross merchandise value (GMV), or total sales proceeds for all items it sold in 2005. Since then, their commercial GMV had grown faster to become a much larger portion of the business, with one-third of the commercial GMV growth coming from acquisitions.
Off Wall Street noticed that DoD accounted for ~24 percent of GMV and 74 percent of 2012 operating profits, much higher than investors realized with respect to operating profits. Its subsequent research showed that recent growth in DoD business appeared unsustainable and a material portion of DoD revenue was at risk from base realignments coming to an end and troops returning from Iraq and Afghanistan.
LQDT had two contracts with the DoD: a scrap and a surplus contract. There was less financial data available on surplus contracts than scrap contracts, under which LQDT retained 23–25 percent of net profits on scrap sales. More important, the surplus contract term would end in December 2013, and DoD could introduce a competitive bid process. (This information is based on Off Wall Street’s discussion with sources familiar with the DoD process.)
LQDT also had significant customer concentration in its commercial business, with Walmart and Acer together accounting for ~50 percent of 2012 commercial GMV. A LQDT competitor told Off Wall Street that certain Walmart personnel in the reverse supply chain were furious after LQDT acquired Jacobs. They moved some uncontracted volumes away from Jacobs after learning that the contract was too favorable for LQDT, presumably at Walmart’s expense. Jacobs derived 70 percent of its revenues from Walmart, and the loss of more contracts could significantly dent GMV growth.
Off Wall Street’s report on July 1, 2012, caused the stock to plunge 25 percent, but it recovered most of its losses over the next two months. The recovery was short lived, as LQDT fell ~20 percent in October after reporting lower than expected September GMV data.
Source: Off Wall Street.
Recap
• Avoid dangerous short stories that involve a long runway of sales growth. Investors can pay up for multiple years of sales growth. Look at the potential market size of growth companies to determine if the market exists. Avoid shorting companies with a good growth track record and management.
• The main thing successful shorts have in common is that their business model is not going to produce the sales and earnings that are expected by the market. Psychological disappointment changes the way investors view the company and creates the revaluation downwards.
• Short ideas naturally need more discovery to reach conviction than longs because the information is harder to come by. It takes a lot more work and interviewing to find sources of information not available in the mainstream.
• Accounting issues are symptoms of larger problems. Accounting issues, in themselves, can be solved by good management if they have a good business model, but fundamental problems are hard to overcome.
Part III
Risks and Mechanics of Short Selling
10
When to Hold, When to Fold
Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.
—WARREN BUFFETT
THE 1980 GRAMMY-WINNING track by Kenny Rogers captures the essence of managing risk: “You got to know when to hold ‘em, know when to fold ‘em, know when to walk away, know when to run.” Is it a surprise that many stock investors and traders love the games of poker and blackjack? Both poker and investing need at least three things to play: skills, philosophy, and money. Successful investors and poker players make insane bets only when odds are insanely in their favor. At the same time, they are not shy about cutting their losses or even folding early.
I have used various examples throughout the book to make the case that managing the risks associated with short positions is much harder than with long positions. Shorting a stock is like a hurdle race, where jumping over the short-term hurdles is as important as reaching the finish line—hurdles such as getting called on the stock, merger and acquisition (M&A) rumors, and short-sale restrictions.
How to Allocate Money Into Shorting Stocks
I watched my portfolio manager make allocation decisions during my early days on the buy side and later gained more secondhand knowledge from interacting with my clients, reading reports from a diverse set of portfolio managers, and watching the interviews of reputed investors. I returned to the buy side in 2014 to help manage U.S. stock portfolios at Columbia Threadneedle, which mostly employs a diversified strategy in managing investment portfolios, depending on the fund’s investment mandate.
In the last year, I have managed two U.S. long-short portfolios with my partner and our capital allocation strategy has been evolved into a distinctly disciplined approach where we allocate capital into three distinct categories of stocks: core (cyclical and non-cyclical), growth compounders, and special situation stocks such that our top 15 to 20 stock allocations constitute half of the portfolio. On the other hand, the short portfolio tends to be diversified and we try to stay away from open-ended growth stories and acquisition risks.
In my interactions with various other mutual fund and hedge fund managers, I have largely found that their allocation strategy is an outcome of their investment charter and their own investing philosophy. Some managers strictly adhere to well-defined rules, such as limiting position sizes to 3 percent of the portfolio, while other managers make more concentrated ad-hoc bets.
There is also a wide range of views on risk management among professional money managers. Some managers formulaically review their investment thesis when the stock moves 20 percent against them and close out their position when the stock moves 30 percent against them. Some managers, such as Bill Ackman, can hold on to their high conviction idea for years, while others may even increase their bets when the stock moves materially against them.
Optimal allocation and prudent risk management can limit downside. Analyzing developments since the initial investment is critical to making allocation changes and risk management decisions. This chapter presents a few cases from an analyst’s point of view on when it makes sense to hold or fold, as well as on the risks in shorting hot stocks or crowded shorts. I will share my experiences as a portfolio manager in the future editions of the book.
Hold When the Story Doesn’t Change Materially
It is more an art than a science to analyze new developments that might alter your investment thesis. In some cases, a company’s strategic decisions to fix large problems may seem as futile as fixing a broken leg with a Band-Aid. For example, Research in Motion promoted its new tablet product in 2011 in an attempt to distract investors from problems with its flagship Blackberry phones.
In other cases, Wall Street analysts can make short-term tactical buy recommendations on troubled companies. As we saw in the case of Office Depot, a bulge bracket analyst upgraded his recommendation from sell to neutral, citing his channel checks. The stock rose 10 percent on the upgrade. There was no evidence in his report to suggest that the company was working on a turnaround plan amid industry decline, and competitive issues remained. It made sense to hold our position and I remained bearish.
Troubled companies seem to attract more speculators and M&A rumors, as we saw in the case of telecom carriers. Companies can try to kick the can down the road by getting bigger through mergers, but they mostly fail to attract suitors on their terms. Their management can make unreasonably bullish forecasts, attracting new investors who underestimate the risks. The management keeps handholding Wall Street to unrealistic guidance and eventually disappoints everyone.
CASE STUDY:
F5 NETWORKS (FFIV)
F5 Networks designs and sells application delivery controllers (ADCs)—hardware appliances that allocate incoming traffic across servers
in a data center. Bulls viewed F5, a major player in the load balancer market with over 50 percent market share and 30 percent operating margins, as a play on Internet traffic growth, data center virtualization, and cloud computing.
Off Wall Street formed a variant view when its research found that large data centers such as those operated by Amazon, Google, and Rackspace were bypassing F5’s off-the-shelf ADC products to build their own custom equipment. The primary reason was cost. As more of the growth in computing power and data handling consolidated into such large entities in cloud computing, hardware vendors like F5 could benefit far less than what bulls expected.
F5 sold its hardware at very high prices (~$400,000 for the highest end appliance). Large-scale users could save half the price by building their own hardware from commodity components, and industry contacts confirmed that there were overwhelming incentives to do so. Resellers, who accounted for ~85 percent of F5 sales, were expecting enterprise hardware sales to decline and were shifting their business models away from hardware.
F5 faced increasing competition in hardware from A10 Networks, an emerging player that offered similar functionality at a lower price point. Software-only ADC vendors, such as Zeus (acquired by Riverbed), were gaining traction by offering similar functionality at a meaningfully lower price. A10 claimed to offer a $15,000 device that was comparable to a $60,000 F5 device. F5 struggled to compete as it sought to protect its hardware franchise.