Short Selling In A Bull Market – Common Mistakes In Security Selection by Greg Blotnick, CFA
It was June 22, 2015 when both articles came out. The NY Times authored a piece titled “The Loneliness of the Short-Seller” and later that day the Financial Times released “Shorters needed.” If past is prologue, the media tends to do a fantastic job at marking turning points – all the way back to Barrons’ infamous cover story “The Death of Equities” in 1979. Contrarians should take note, as the S&P has drifted even higher since journalists lamented the death of short selling sixteen months ago.
Short Selling
Today’s market, while not egregiously overpriced, offers poor risk-reward in comparison to the opportunity set investors were presented in the early 1980’s: an S&P 500 trading at 8-9x earnings combined with double-digit interest rates in decline. 2016 presents the inverse: a fully-valued market combined with rates at the zero-lower bound and climbing, serving as a headwind to further multiple appreciation. For those of us not forced to be fully invested, this is an ideal environment to overweight cash and begin stalking new short ideas. Here are three of my preferred criteria:
1. Cheap Stocks Make Better Shorts Than Expensive Ones.
- Investors are easily swayed by the allure of a low trailing P/E ratio. It saves them from having to forecast the future, which requires work, and serves as a simple crutch for justifying an investment to colleagues or investors (“the stock is cheap!”). Experienced investors and short sellers know that a low P/E ratio is the sign of a business facing severe headwinds – either cyclical or secular – and that earnings are likely in decline. Forecasting earnings two or three years out often reveals that what appears to be 10x trailing earnings is a value trap, as the stock is trading at 20x forward or 30x earnings multiple years out.
- For these optically cheap short candidates, secular headwinds are preferable to cyclical. Share prices of cyclicals tend to move swiftly and unexpectedly from the bottom and can quickly lead to large losses, especially businesses with heavy financial and/or operating leverage. At the risk of stating the obvious, the best short candidates are melting ice cubes where the probable outcome is a slow bleed to zero; rather than having to time covering a short, the decision is made for you when the stock gets delisted. Jim Chanos is often asked about the asymmetric upside risk from a short and gives a simple response: “I’ve seen more stocks go to zero than infinity.”
2. Go Where There’s Dumb Competition.
- One under-utilized screen for short candidates: stocks with high retail ownership. The general investing public tends to fall for the usual “Three F’s” of short schema (fads, frauds and failures) far more often than professional investors. The ETF/passive boom has spawned profitable short targets as well, particularly decaying levered ETF’s or the rise in oxymoron “low-volatility equity” products. Quantitative screens exist to find ‘retail clustering’ but qualitative analysis is more useful: go through SeekingAlpha comments sections, StockTwits’ “trending” bar, and the Twitter stream for a given stock.
- Other than fads and frauds, yield plays are honey to the retail bee – particularly in the current low-rate market environment. Some recent examples include MLP’s/offshore driller drop-downs or other ‘yieldco’ capital structures that have no fit with the economics of the underlying assets and exist primarily to enrich management at shareholders’ expense. Screening for stocks with double-digit dividend yields often reveals short candidates, as the market is signaling the dividend is unsustainable and likely to be cut or suspended entirely. The caveat is that timing these shorts can be difficult as they are most akin to shorting a bond – high cost of carry accompanied by an event where the instrument loses 25%+ of its value overnight.
3. Beware The Embedded Macro Bets In A Stock.
- David Tepper frequently preaches this: investors often ignore the embedded macro bets they are making. For example, consumer staples today trade at 20-25x earnings despite flat top line and mediocre earnings growth. Why? In an environment with zero and negative bond yields, a 2-3% dividend is a healthy substitute and offers the added benefit of pricing power to offset inflation. The same can be said for some REITs and Utility stocks – it is simply a market truism that stocks occasionally disconnect from fundamentals for long periods of time. If you are short any of these three sectors and rates continue their rapid decline, you will lose money regardless of the business’ underlying performance.
- Other examples of dangerous embedded macro bets would be shorting commodity-linked energy or basic material companies. The equity in a distressed and over-levered shale driller may be worthless with WTI crude at $30, $40 or $50 – but being short said driller as crude goes from $30 to $50 can quickly lead to a 500%+ unrealized loss. Pay attention not only to leverage but to how the stock price has historically correlated to the commodity it tracks and what sort of beta it has to the underlying.
Good luck trading,
Greg Blotnick, CFA
About the Author
Author biography: Greg Blotnick is currently a long/short equity analyst at a private investment firm, covering consumer, TMT and industrial stocks. Greg has spent his entire career in the asset management industry and served as a fundamental analyst for former multi-billion dollar hedge funds. Greg’s experience spans multiple investment strategies including long/short equity, credit, event-driven and capital structure arbitrage. Greg holds an MBA from Columbia Business School and a B.S. in Finance from Lehigh University, and is a CFA Charterholder. He can be reached at [email protected].
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