Short Selling: Cleaning Up After Elephants by Guy Judkowski

H/T MarketFolly

Short Selling – Introduction

I have been a professional short seller for over 20 years. Early in my career, a colleague described our job as basically being paid to clean up after elephants. Later in my career, I met someone whose summer zoo job actually involved cleaning up after elephants. After comparing notes, the jobs seemed very similar. Both involved a whole lot of s_ _t!

I doubt very few people ever intend to become a short seller. I know I didn’t. After receiving a BA in International Relations from the University of Pennsylvania in December 1988, reality slowly dawned on me. With the possible exception of philosophy, I had just earned one of college’s least useful degrees. So I did what every LA Law watching student did in 1989. I went to law school. One summer toiling at an insurance defense law firm convinced me I would never be able to successfully account for my day in 6-minute increments. The following summer, I landed an internship with the Internal Revenue Service.

They loved me primarily because my softball skills proved useful to the legal department’s softball team. Workwise, nobody knew what to do with me. I had free time to do stock research all day on the Nexis/Lexis research terminal. It gradually dawned on me that I really enjoyed doing stock research so after law school I took a job as an analyst at a money management firm in Bryn Mawr, Pennsylvania.

The owner of the firm had once been the head of Drexel Burnham Research (which later became famous and ultimately infamous in the 1980s due to Michael Milken and junk bonds). While in his office one day, I noticed him reading a newsletter called Financial Statement Alert. The service highlighted between 5-8 companies per month that were using aggressive accounting techniques in order to manage earnings.

My interest piqued, I read all the back issues in short order. Next, I went to the library and read as much as I could on short selling. I learned about NYU accounting Professor Abraham Briloff who in the 1960s wrote papers criticizing how companies manipulated earnings. I also located a copy of Thornton O’Glove’s Quality of Earnings (1987). This book laid out in great detail how forensic accounting helps identify earnings quality problems by emphasizing the importance of detailed analysis and investigation of a company’s financial statements. Identifying problems before they are well known creates excellent opportunities on the short side.

The sections that delved deeply into accounting bored me. I admittedly was not interested in learning all the nuances of accrual-based accounting. I did find fascinating the sections on due diligence, working capital red flags such as high accounts receivable and inventory, and the concept of differential disclosure (seeking out wording changes in federal filings and company announcements).

Perhaps some of my legal training helped me to be more naturally attentive to the necessity of critically reading federal filings and proxy statements. The premise that slowing sales coupled with deteriorating working capital is a red flag made common sense to me. After all, my stepfather owned a furniture store so I had a front row seat to the importance of managing your cash flow, not allowing your inventory to pile up, and the importance of collecting on your receivables.

Short Selling – Chapter 2: Beginner’s Luck

There was a remarkable rookie pitcher in 1976 named Mark “Birdman” Fidrych who went 19-9 and won Rookie of the Year (shortly afterwards, he suffered arm injuries and was finished after just 5 seasons). My rookie season as a short seller was almost as good. I published 9 short sell reports between October 1993 and March 1994. The following table shows my record:

Short Selling

Brooktree Corp, down 17% in 6 weeks; Fruit of the Loom, down 32% in 4 weeks; Eagle Hardware & Garden, down 46% in 4 weeks; Regal Communications, down 31% in 4 weeks; SLM International, down 40% in 5 weeks. There was a small loss (9%) in Cooper Tire & Rubber and 3 open short recommendations (Empi, Pyxis, and Alaska Airlines) when I stopped publishing and left to work for a hedge fund. I later co-managed a successful short-biased hedge fund for 13 ½ years and also published short sell reports (The Accounting Workout (1993-1994), The Short Seller’s Report (1996-2006)) and co-published red flag newsletters (Balance Sheet Watch (1998-2006), Earnings Workout (2011-2012)).

See full PDF below.

Short Selling: Cleaning Up After Elephants