I wanted to change up the pace, from looking for cheap companies, to looking for expensive companies. Welcome to book number 9 in my top 10 investment books of all time, “The Art of Short Selling”. This book has been written by Kathryn Staley. Kathryn is an expert in the field of short selling and the book has a wide following by many successful hedge fund managers.
Despite never investing on the short side, I am intrigued by short selling and I found this book to be helpful for traditional buy-and-hold investing too.
What is short selling?
Short selling is betting that a stock price will fall. A popular pastime for large institutional investors. Practically, this happens by borrowing the stock from a securities lender, and selling the stock. The investor then needs to buy back the stock for less than the sale price i.e. sell for $10, buy back for $5. Once the stock is bought back, it is returned to the securities lender to close the position.
Why do these short sale opportunities exist?
Opportunities for short sellers exist for a few reasons. The primary reason being the manic-depressive nature of financial markets. The pendulum swings between greed and fear driving valuations up or down, creating a gap between price and value. Short sellers provide a hand brake to false optimism, thereby increasing market efficiency.
Secondly, the bull case is aided by the bias of investment banks and brokers to write favourable research reports about companies. Investment banks often wear two hats, one as advisor, and one as equity research broker. These different hats create competing interests. Investment banks receive fees for advisory work, capital raisings and stock placements, creating a conflict.
Identification of Opportunities
Kathryn uses three broad categories to identify investment opportunities:
- Companies in which management lies to investors or obscures events that can affect earnings – think Enron;
- Companies with inflated stock prices that suggest a speculative bubble – think any of the tech stocks from the 2000s; and
- Companies that will be affected by a negative external event – think of the structural shift occurring in print media today.
Once a company has been identified, the investor should look for certain common characteristics. Kathryn, believes the following characteristics are a good place to begin.
Characteristics of Short Investments
- Aggressive accounting, such as recognising revenue and profit early;
- Management selling that is contrary to public endorsements;
- Fad or bubble stocks usually marked by a large price rise over a short period of time; and
- Overvalued assets or an ugly balance sheet including high levels of debt which can sink even great businesses.
If one or more of these characteristics is present, short sellers start the process of compiling comprehensive data. This data includes financial statements, interviews and discussions with industry experts etc. Let’s explore these common characteristics in more detail.
Most companies produce financial statements that are comprehensible to a person who understands accounting. Sometimes, however, it is very hard to work through the financial accounts. If you are having trouble reconciling the financial accounts, you may have identified a short candidate. Aggressive accounting includes recognising revenue and profit too early, capitalising expenses or inflating assets. It is important to understand the cash flow statement, as this will provide a more accurate snapshot of the business and is subject to less manipulation by management.
This is an important signal from management. A strong correlation exists between management buying/selling and stock performance. Beware of management teams selling stock while publicly endorsing the company. Kathryn highlights insider selling as a wonderful leading indicator to future problems.
Fads & Bubbles
Kathryn provides some good examples of fads in her book. An example of a fad in the early 90s was the iced tea drink, Snapple. Snapple was popularised by the hit TV show Seinfeld. Snapple was a good old fashioned fad and a stock market darling at the time. Snapple traded on 64x earnings in 1992. Kathryn points out that overvalued stocks can become more overvalued. This is what happened to Snapple, the price increased rapidly despite its high valuation, squeezing short sellers. Unfortunately, stocks can stay overvalued longer than short sellers can stay solvent. Short sellers are advised to wait until the cracks start to appear before shorting a stock.
Overvalued Assets or Ugly balance sheets
Debt is the number one destroyer of investment capital. A high debt load can sink any successful business if it gets into trouble. Kathryn cites the balance sheet as an important place to look for problems. As a fundamental investor, it is important to avoid high levels of debt. It stands to reason that debt is a great place for short sellers to begin their fact finding mission.
4 Major Sins of Short Sellers
Kathryn provides four noteworthy sins for short sellers to consider. I believe these sins are as relevant to long only investors as short investors.
Too little work is dangerous for any investor; however, it appears to be even more treacherous for short sellers. Usually this is prompted by shorting someone else’s idea – a recipe for disaster.
The ego will get any investor into trouble, but again seems to hit short sellers hard. Especially when they are left defending their ego as the short position turns on them. Short sales tend to be higher profile as the short sellers attempt to win the market over to their view.
The biggest mistakes occur when investors short great companies based on a stretched valuation. High quality companies can quickly grow into their valuations. Furthermore, stocks can stay overvalued for a very long time.
For all investors, timing is huge. Kathryn points out that short sellers often underestimate the insanity of the public market. Investor ebullience can keep a stock price up for a long time, even in the face of no earnings.
Learnings for Long Only Investors
Kathryn points out that the discipline to short sell requires as much work (if not more work) than traditional fundamental analysis. Fundamental long only investors can benefit from the intensity short sellers bring to cash flow dissection and understanding the reality underlying accounting manipulation. This is an important discipline to understand. Overall, studying short sellers is a great way to improve long only investing.
I hope you found this review to be beneficial even if you are a fundamental long only investor. I should say that short sellers are not doing anything wrong. Despite, some high profile Australian CEOs complaining about them from time to time. These investors are providing price discovery and arguably making stock prices more efficient. For me, personally, I have never felt very comfortable short selling. However, I respect the role short sellers perform and try to use their insights to improve my investing.
Lachlan is the founder and CIO of Swell Asset Management, a boutique investment manager specialising in global equities.