Value Investing

Short Sellers: What’s Not To Love?

Sui Generis Investment Partners monthly commentary for November 2015 titled, “What’s Not To Love?”

Friends & Investors,

October was a bit of a strange month for North American equity investors. The schizophrenia that has come to define the stock market in 2015 only became more acute as bad news became good news and the idea of a US rate hike in December was taken off the table. To illustrate our point here is a brief collection of headlines from the month of October from our favorite economists: “US ISM Shows manufacturers barely hanging on”, “Is China experiencing a Hard Landing?”, “Weak US payrolls suggest Fed will delay rate hike”, “US trade deficit widens sharply in August”, “US confidence drops back to 3-month low”. While the sample size we have provided is admittedly small, you can extrapolate to get our point; nearly all of the economic news released during October was bad, so of course markets reacted logically and rallied. The “bad news is good” trade allowed US equities to post their best month in four years on the idea that not only would rates stay low, but the door was now open to further quantitative easing. The Sui Generis Investment Partners Master LP continues to outperform the TSX by double digits and we used the October rally to “re-load” on some of our preferred short positions and markedly increase our net short bias. We will continue to provide our investors with a low correlation to equities and protect them during what we can only describe as a very strange market.

The new evil sweeping capital markets, short sellers

Bear with us while we hypothesize for a moment. While we cannot speak for all of you, we’re going to assume that when considering investment bankers, brokers et al, the values that are held in the highest regard are intelligence, hard work and most important, honesty. We emphasize honesty because both intelligence and hard work are a dime a dozen in the investment community, everywhere you look there are smart people working hard. Honesty however, is an abstract concept on Bay Street; given that most of the opinions you (and I) hear are coming from individuals who are conflicted in one way or another, it is nearly impossible to gauge the degree to which the person conveying the message believes what they’re saying or writing. Analysts, salespeople, traders and brokers are all employees of firms that have corporate relationships with companies and thus, get paid by them. We know we’re not supposed to suggest such things, but is it possible that these people are influenced by the fact that their livelihood depends on these corporations doing well, issuing more stock and doing more deals with large fees attached? So it is with the straightest of faces that we suggest you pay particular attention to the new evil sweeping capital markets, short sellers.

The single biggest reason that the investing public responds with both anger and derision when confronted with the opinion of a short seller is fear; specifically a fear of the unknown, or perhaps put another way, fear of what else they may not know. We would venture to guess that the vast majority of shareholders and even analysts who covered Valeant Pharmaceuticals had never heard the name Philidor, the now infamous pharmacy that became the proverbial “smoking gun” in the short report brought forth by Citron Research. Here in Canada, we saw the look on investors faces when we told them the short report on DH Corp we had just studied pointed out that DH had purchased an American company that was currently sanctioned by the FDIC; they had no clue. So the question is this; Are short sellers the “market manipulators” they’ve been branded as or are they simply telling the truth and trying to profit?

Is a short report at all different from someone pushing investors to buy a stock? Diligence is done, an opinion is stated and we would suggest shorts are far less conflicted because their only motivation is to be proven correct, otherwise there is no money in it. When a buy recommendation turns out to be wrong, there is an acceptance amongst all involved. The market turned on the company, they didn’t get a sales contract we expected them to get, the commodity price dropped, management has it all figured out now…It doesn’t matter what the excuse is, a buy report doesn’t need to be correct, it just needs to be there when the company needs to raise money, they know which investment bank to call. A short sellers report needs to be correct because the reaction du jour of the targeted companies is to sue the author.

Somewhat amusingly, we too have felt the wrath of shareholders who didn’t want to hear our viewpoint and chose to brand us as manipulators. A few months ago during an interview on BNN we suggested that a particular Canadian short position would, on our numbers, “run out of money” by the end of the year. The negative free cash generation of this company was staggering, but analysts were more than happy to point to their strong EBITDA (a nearly pointless metric for a capex heavy business) as a reason to own the stock, along with a big dividend that they couldn’t afford. On air, we suggested that the company couldn’t consume cash like that forever and that they were treating capital as though it were infinite, followed by a suggestion that they ought to raise money quickly to plug this hole in their balance sheet.

We were promptly inundated with angry emails and suggestions that we “lawyer up”, as though it were illegal to have an opinion. We were called reckless and irresponsible and were very matter-of-factly told that we were going to “get smoked” on our short. To be clear, no lawyer was ever required because we hadn’t communicated anything more than our opinion that was substantiated up by many hours of research. Two weeks later the company announced a $75 million equity financing that sold very poorly and had to be re-priced downward, at which point we covered our short as the company was granted a stay of execution. So Bay Street did its job and provided financing to a company that desperately needed it and we did our job by pointing out that financing was required, but because it was an against consensus opinion we were accused of being dishonest. The investors who suggested we seek counsel likely had no idea that the company with an enterprise value of $1B had burned through north of $100 million in the previous twelve months because they were happily collecting their dividend cheques, which as we stated in our July Multiple Thoughts, is supposed to be in indication of underlying strength of the business, not an attempt to get the stock multiple up.

We certainly understand that investors often hear what they want to hear, and don’t want to believe that they’ve been wrong on a stock. We always apply a healthy dose of pragmatism to our brand of portfolio management as we believe that is the only intelligent way to consistently analyze equities; if the story changes so too must we. With all short positions, we undertake what we would proudly call an exceptionally high level of due diligence and when we have the opportunity to report on our findings, you can rest assured it’s honest.

Sincerely,

The Sui Generis Team

Short Sellers SIR

See full PDF below.