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The long and the short of investing

The western world is living through a unique period in its history. Social, business, technological and generational disruptions are converging, including seismic shifts in the relative power of continental empires. This presents an opportunity for a strategy incorporating ‘short selling’ (also called a ‘sold portfolio’). Currently relegated to the ‘alternative’ category of a portfolio, it could arguably be considered a core for many investors.

Change of course is a constant but much rarer are the multiple fronts on which it is occurring, and its pace is unique.

How does short selling work?

Imagine you discovered your local car dealership would soon be launching a 50% off sale for the same model car your neighbour owns. Is there a way you could profit from this hypothetical scenario?

If your neighbour is open to renting their car to you for a few weeks or months, with the promise of course that you’d return it, you could immediately sell it at the current market price (say, $30,000) then use the cash to purchase the same car in the local dealer’s sale (for $15,000). You can then return the new car to your neighbour and pocket the difference as your profit (in this case, $15,000).

By borrowing shares and paying the lender interest and the dividends, an investor can build a portfolio of ‘sold’ positions, also known as ‘short’ positions, which aim to be re-purchased at lower prices.

I have deliberately kept the short selling analogy brief to illustrate the concept.

In 1886 when Karl Benz first drove his Benz Patent-Motorwagen horseless carriage past a blacksmith, it would have been impossible to predict which manufacturer of this world-changing technology would succeed. In the US alone there have been 1,665 car manufacturers that are now defunct. Picking a winner, even in seismic shifting technologies, is difficult. It was far more challenging to predict the winning car manufacturer than it would have been to pick the blacksmith as the loser. And therein lies an opportunity.

Now add to the disruption narrative, the ‘new normal’ environment of lower returns. If it is true that interest rates normalise and corporate profits grow at slower rates or margins mean revert, then it is also possible large double-digit aggregate stock market gains will give way to much more modest numbers.

The shorting opportunity

There are many reasons why an opportunity to establish a short position may be presented but practitioners cannot simply flip the process and philosophies of value investing. If value investing involves buying quality at discounts to intrinsic value, a successful short selling strategy is not simply selling expensive poor quality companies.

 

  • Fraudulent behaviour

 

 

Perhaps the most frequently cited strategy, but surprisingly least attractive on a risk-reward basis, is fraud within a company. Accounting and executive frauds typically produce market misperceptions. A very good fraud by definition can generate a misperception that lasts many years, and for this reason selling such discoveries in the hope of profiting from a subsequent share price decline upon the fraud’s exposure inheres great risk. To mitigate this, participants using this strategy will often publicise their discovery and use the media to lubricate the dissemination of information (or misinformation, if they’re incorrect). A recent example of this activist technique is Pershing Square’s very public criticisms of Herbalife and their argument that it is a pyramid scheme.

 

  • Thematics and structural decline

 

 

The disruption idea fits into this category, which also includes structural overcapacity, deleveraging cycles and obsolescence. For example, the change in entertainment viewing habits, the crackdown on corruption in China, the changing competitive landscape in the Australian supermarket sector and the adjustment to lower coal and iron prices can all be included in this category.

 

  • Unexpected events

 

 

When expectations diverge from reality a third category of opportunity emerges. We have observed that sell-side analysts can sometimes be slow to downgrade their hitherto-optimistic earnings, revenue and same store sales expectations, even in the face of evidence the outlook for a company may be changing. When expectations diverge, an opportunity to take advantage of the subsequent downgrades can present opportunities for returns.

 

  • Financial risk

 

 

This final category can accelerate the potential of the first three. Financial risk includes balance sheet risks from excessive leverage and exposure to regulatory changes.

Of course, the best opportunities will have aspects or elements of several of the above categories and investors should ask why little of their portfolio is allocated to take advantage of the shorting opportunities presented every year.

Whether you call it creative destruction, transition or disruption, the result is that there will always be winners and losers. If betting on the little white ball landing on red is acceptable, is betting that it doesn’t land on black also acceptable?

A place for short selling

Markets serve the real economy best when they efficiently allocate capital and effectively price in all available information. In a 2009 consultation paper, the UK regulator, the Financial Service Authority, explained:

“We have consistently made it clear that we regard short selling as a legitimate investment technique in normal market conditions … Short selling can enhance the efficiency of the price formation process by allowing investors with negative information, who do not hold stock, to trade on their information. It can also enhance liquidity by increasing the number of potential sellers in the market."

Limiting the ability of rightfully sceptical investors to take the opposite side of a trade undermines efficient capital allocation and effective pricing.

Some investors believe that the risks of building a sold portfolio are unattractively skewed to the downside. The argument goes that the most you can make shorting a stock is 100% if it goes to zero, but the losses are infinite as the stock rises. The retort is that more stocks go to zero than to infinity!

More importantly and less understood however is the ability to compound returns. When selling a stock short, cash is received. If the stock does indeed fall in price, an investor can add to short positions without adding any additional capital. If one starts with a short position of $US100 with no other cash in their account, and the stock goes down to $US50, one can, without adding any more cash capital to the account, short additional shares. And if the position’s direction remains favourable, returns can be compounded.

Optimising with both long and short positions

The final point to be made is that a carefully-crafted strategy that incorporates both a purchased portfolio of high quality equities, and a portfolio of sold positions from the previously mentioned categories, can also reduce risk.

One portfolio buys shares in high quality businesses to make a profit from rising markets and prices. Another portfolio sells shares of businesses that are deteriorating so you have the opportunity to make a profit from falling markets and prices.

If these portfolios are the same size, as the market moves, one portfolio is likely increasing in value by the same amount as the other is decreasing. Your market risk has effectively been neutralised. You now have zero exposure to the vagaries of the general level of the market.

By way of example, a portfolio may have invested $100 in extraordinary businesses, while simultaneously having received $60 for the sale of another portfolio of sold positions. Cash is received for the sale of $60 worth of sold positions, which can be simply held in cash or used to add to the existing portfolio of purchased extraordinary businesses. If the $60 is held in cash, then the $60 worth of sold positions offsets the $100 of purchased extraordinary businesses and the investor’s net exposure to the vicissitudes of the market is $40.

All things being equal, if the market were to subsequently fall 10% an investor with a portfolio displaying the above characteristics would expect to see the portfolio decline by only 4%.

Along with overseas exposure, participation in the effects of a heightened period of disruption and structural decline and the possible reduction in risk from a lower net exposure to the market are merely a few of the reasons why investors in volatile stock markets might consider whether such strategies could emerge from their ‘alternative’ allocation status and even become part of their core portfolio.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any individual.

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4 Comments

Andrew Brown

November 05, 2015

Just to add. I do believe VALUATION is shortable but accept this is a contrary view - you have to plenty of work & have deep pockets. Plenty of examples where you would come unstuck but shorting erroneously valued market darlings adds a bit of beta to things. One thing Roger didnt mention is the asymmetry between averaging down on a long bet going down but where you are happy with the thesis and averaging up on a short. You often cant as there may not be stock available to short sell in certain situations. Happened to me a couple of times though worked out OK in the end. Some unscrupulous companies try to influence their main shareholders not to lend stock. Good article.

Tony

November 05, 2015

Roger has deep pockets and many happy investors in his funds.

Jerome Lander

November 05, 2015

Good article - thank you. The benefits of long/short investing are not well understood. Interestingly, many well informed individuals choose to invest the bulk of their portfolio in these strategies rather than in long only investing, simply because long only investing is usually too vulnerable to market risk and hence large falls. In contrast, long/short investing has a greater variety of return drivers and if done well is very well aligned with the objectives of high net worth and sophisticated individuals when investing in equities. It is important when choosing long/short equity funds to ensure that they can actually short well and have a well diversified short portfolio to mitigate the risk of individual short positions.

The greatest pricing anomalies in the market - and hence opportunity for active investing - is in fact found among fraudulent companies. A diversified short portfolio of fraudulent companies mitigates the risk of an individual company staying mispriced and provides investors a unique and diversifying return stream. While great in theory, such a strategy is not usually offered by fund managers or possible for individual investors to create due to the challenge of identifying sufficient numbers of fraudulent companies to short. We are lucky here in Australia in that there is a fund manager who runs such a strategy within their global long/short fund, and is known among the global funds management industry for their shorting expertise (Bronte Capital). There are also other good long/short funds based in Australia from which investors can build a 'core equity portfolio' aligned with their objectives.

Gary M

November 05, 2015

The type 2 and 4 identified – Thematics and Financial Risk - take time to come to fruition – but shorting requires very short timetables or extremely deep pockets.


 

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