The Big Short (Interest) A Moneyball-Style Look At Short Interest by Adam T. Eagleston, CFA and David W. Wagner III – Opus Capital
- Within the small cap space, stocks with the highest short interest underperformed by a wide margin over the last five years.
- The effect is more pronounced in value, where companies with the highest short interest lagged the Russell 2000 Value by over 9% per year; excluding the speculative years of 2012 and 2013 doubled the level of underperformance to 18% per year, on average.
- Recently, we experienced an anomalous period (2/24/16 – 3/4/16) when the best performing stocks were those with the highest short interest.
- The top-ten performers during this time had an average short interest of 17%, and were typically energy companies with crushing debt loads and share prices of less than $1; the credit markets are predicting many of these names are bound for bankruptcy.
- While possible, it is unlikely for investors to win by owning heavily shorted names, and Opus typically avoids playing this losers’ game.
The Big Short (Interest) – A Moneyball-Style Look At Short Interest
The Oscars were presented a few weeks ago, and much to the chagrin of us investment types, the award for best picture did not go to The Big Short. The story of the contrarians who predicted the housing market collapse and how they turned those beliefs into billions by shorting various financial instruments is indelibly etched into the mind of every investor, becoming almost mythical in nature. However, the Academy deemed Spotlight, which features investigative reporters taking on a deep-rooted conspiracy, the best picture.
Much like investigative reporters, investors must also be diligent in separating fact from fiction, and avoid accepting as valid the myths that litter the collective mind of the market. As John F. Kennedy puts it, “The great enemy of truth is very often not the lie–deliberate, contrived and dishonest–but the myth–persistent, persuasive and unrealistic.”
One myth that we hear frequently, especially among value investors, is that high short interest presages future positive returns for a stock; in other words, the mythical short squeeze is real, and it happens often. Short interest is expressed as the percentage of shares that have been sold short, i.e., borrowed from an owner and sold at today’s price in hopes of covering at a lower price in the future, relative to the number of shares currently outstanding.
The reason these investors cite is that heavily shorted stocks have an inherent tailwind, given embedded demand from short sellers who might eventually need to cover their positions quickly. In this event, a stock’s price is driven higher because there is excess demand for a stock and a lack of supply. The value investor looking for the short squeeze is convinced his or her investment thesis for owning a heavily shorted stock will be proven correct. Once the market realizes this, the stock’s price will be pushed higher by the combined effect of positive news and the constricted supply of the stock. This represents a double whammy, so to speak, for the shorts.
Like our investigative reporter brethren, we want to diligently investigate matters for ourselves, and evaluate the effects of short interest on stock price performance. Does investing in stocks with a high short interest bring investors Joy, or is their experience more like that of Leonardo DiCaprio in The Revenant?
First, let’s look at what has happened historically. To begin our investigation, we grouped the constituents within the Russell 2000 (“R2K”), Russell 2000 Growth (“R2KG”) and the Russell 2000 Value (“R2KV”) into equally-weighted portfolios based on their short interest decile to see how each performed over a period of time; decile 1 contains stocks with the lowest short interest, while decile 10 has the highest short interest.
Looking back on how these stocks have performed over a five-year period ended 12/31/15 shows that stocks in higher short interest deciles performed poorly when compared to companies in the lower short interest deciles. This held true for the R2K, R2KG and R2KV, though was most pronounced among value stocks, where decile 10 names were involved in a Crash, coincidentally the title of the 2005 best picture.
This downward linear relationship shows that there may be something to poor performance being partially attributed to short interest. However, perhaps this is just hindsight bias, and stocks that have performed poorly see short interest escalate on their way lower.
To address this issue of hindsight bias, we look at the question another way, and delve into the realm of predictive analytics. Taking the previous results one step further, we again grouped the constituents within the R2K, R2KG and R2KV into equally-weighted portfolios based on short interest decile. Instead of looking back, we divided the universe into deciles based on short interest at a point in time (calendar year ends 2010-2014), looked at how they performed the following calendar year, then linked the calendar years to derive a cumulative five-year return (2011-2015).
This predictive analysis also demonstrated that the higher the short, the more difficult it is to outperform. These results indicate that short interest is a possible predictor of future performance across both value and growth stocks in the small cap space.
Taking a more granular look within the value universe is even more illustrative. The table below shows the relative performance within the R2KV for deciles nine and ten for the years 2011-2015. During speculative periods when low-quality dominated, e.g., 2012 and 2013, being in the most highly shorted names offered only a slight performance advantage, if any at all – a very surprising find. Conversely, when the market demonstrated meaningful volatility, the most heavily shorted names tended to underperform by wide margins, as we saw in 2011, 2014 and 2015. When times were not As Good As It Gets, decile 10 consistently plumbed the depths like the eponymous ship of 1997’s best picture winner, Titanic.
This performance begs the question – is short interest a factor that needs to be evaluated for predicting performance of a stock going forward?
At Opus, our mantra is invest with the wind at your back. This philosophy underpins the key tenets of the quantitative part of our investment process and is also an integral part of our qualitative analysis. While we do not make investment decisions solely on short interest, we are cognizant not only of the percentage of shorted shares, but also the direction in which a company’s short interest percentage is heading. Not only does Opus monitor short interest during our initial fundamental research, but we track short interest for each of the holdings in our portfolio. We tend to avoid stocks in the higher deciles of short interest, given that our nearly two decades of experience, as well as our research, have taught us that although highly shorted stocks can outperform, the odds are stacked against you.
Birdman (or the Unexpected Virtue of Ignorance)
In 2015, Birdman was the winner of best picture. Its full title appends the name of the title character with “or the Unexpected Virtue of Ignorance”. Ignorance of the deleterious effects of higher short interest has recently been a virtue, and the current investment landscape provides unique perspective into one of those rare instances when the quixotic quest to be on the right side of the mythical short squeeze actually occurs. At the end of the 2015, short interest by sector within the Russell small cap benchmarks was as follows:
Energy demonstrated the highest short interest percentage in both the R2K and the R2KV. This is due to the prolonged depression in oil prices, which have been hovering around $30/barrel since the beginning of 2016, and are down 60% over the last 18 months. Lower prices, coupled with staggering amounts of debt on the books of operators who levered up during the shale boom, have investors betting on further declines in share prices, if not outright bankruptcies.
What has transpired over the last few weeks (from 2/24/16, when oil bottomed, through 3/4/16) is a short squeeze of epic proportions. With oil rebounding from around $27 to over $37, the most speculative stocks in the energy sector, i.e., those with the highest shorts, which heretofore were pricing in probable bankruptcies, have rocketed higher. The following table shows the ten best performing stocks in the R2KV from 2/24/16 through 3/4/16. Eight of the top ten slots belong to Energy names, with the two “Durables” stocks performing business in the petroleum shipping business.
To summarize what happened over this period, the biggest winners, which, were higher, on average, by over 150%, had the following traits:
- Average short interest of nearly 17%
- Average ROE of -125%
- Average debt/capital of over 175%
- Average price as of 2/24/16 of $0.84
The same trend held true when evaluating the R2KV’s top fifty performers, which sported an average short interest of over 17% and returned an average of only 85%. Bear in mind, we are talking about a period of a little over two weeks!
Based on Oliver Twist, the musical Oliver! (the exclamation point seems superfluous), took best picture honors in 1968. However, the Academy overlooked a film that has had a much longer lasting impact on pop culture, Night of the Living Dead. The film launched the zombie genre of films and, if you look closely, you may even see the biggest winner of the last two weeks, Ultra Petroleum Corp. (ticker: UPL), up over 229%, lurching around the Pennsylvania countryside, given the company appears to fit the definition of a zombie at this point. So what exactly has convinced investors to jump into this name? Perhaps they were harkened by this statement from the company’s 10-K released on 2/29/16:
“As discussed under Liquidity and Capital Resources, continued low oil and natural gas prices during 2015 have had a significant adverse impact on our business, and as a result of our financial condition, substantial doubt exists that we will be able to continue as a going-concern.”
Or perhaps it was that a company with a market capitalization of $176 million has only $450 million of its $3.8 billion in debt coming due in the next two years, and just maxed out the remaining $266 million on its line of credit.
Here is what the credit market thinks of these 2018 notes, which are currently priced around $0.07 on the dollar.
What we are seeing with this, and many other names, is the very anomalous short squeeze, and if the credit markets are to be believed, this company may be on the end of a double tap in the not too distant future.
So the answer to the question, “is it possible to have a high return in a heavily shorted stock?” is yes. The period from 2/24/16 through 3/4/16 shows that this is the case.
“Is it likely?” is a totally different question, and one where we think the answer is a resounding “no”. Given our desire to protect capital, we avoid highly speculative, heavily shorted names, so it is unlikely we will fully participate in brief, fitful rallies, like the one we have recently seen. However, we firmly believe that over time, investors are more likely to catch a falling knife than a rebounding rocket by speculating in these sorts of names.
To end our Oscar-oriented opus on short interest, we look to a film that, like The Big Short, was based on a Michael Lewis book, Moneyball. The story of how a methodical analysis of baseball statistics helped the Oakland A’s assemble a team of “undervalued” players reminds us a great deal of investment research. The book’s protagonist, general manager Billy Bean, tells a player, “I pay you to get on first base, not get thrown out at second.” Avoiding stocks with the highest short interest typically helps investors avoid getting thrown out at second or, to quote a famed 2012 film, makes “the odds be ever in your favor”.
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