This is part three shorting stocks of a new ten part series from ValueWalk on value investing. Over the past three years, ValueWalk has conducted exclusive interviews with some of the best value managers around and this series is devoted to the most insightful interview comments.
- The Value Interviews Part One: Finding Value – The Process
- ValueWalk The Interviews Part 2: The Value Process
If you’re looking for more up-to-date interviews and ideas, you should take a look at ValueWalk’s exclusive quarterly magazine, Hidden Value Stocks. Each issue contains two interviews with value managers as well as four stock ideas mostly (focused on going long not shorting stocks) and a detailed Q&A session on each idea. Click here to find out more today.
This part of the series is devoted to shorting stocks. Shorting Stocks and value investing do not usually complement each other but our interviewees have all developed their own unique method of profiting from this strategy. In several cases, the short thesis is the opposite of the value case e.g. shorting stocks of bad quality, lying and/or overvalued businesses. The interviewees explain more on shorting stocks in detail below.
Shorting Stocks – quotes
There’s one side of Emerging Value’s portfolio that I wanted to ask you about, and that’s your short book. The majority of your short book is in two key positions, two key ETFs to be exact, TNA and USO. You believe both of these are heading to zero, could you provide some more detail on this?
Sure, I think shorting stocks is a unique and specialist strategy. I always ask investors which would you rather short, a levered or unleveraged company? If you short the levered one, you’re going to get killed if the company does well the equity is going to surge higher, and you don’t stand a chance but if you short an unleveraged company the trade could take a long time to unfold because there’s no leverage.
So, the correct answer is short neither, you short the bonds. When you short the bonds, there’s very limited upside and unlimited downside – exactly what you want in a short. You have to be careful when shorting companies. I think that shorting is a very risky, dangerous game to play. What I do is short, what I call ‘bad Wall Street products’. ETF’s fall into this category. They’re not a company, no one will fall in love with them, they won’t be taken over — they’re just packaged products. If you do your research, you can see that there are quite a few flaws in the way TNA and USO are constructed. A few other ETFs are also exposed to the same flaws: the idea behind the ETF isn’t all that bad, but the implementation of the strategy is horrific.
Take USO for example, the idea was to give average investors access to the price of oil, which makes sense. However, USO doesn’t own any oil; all the fund does is buy futures contracts on a monthly basis. The fund is constantly buying these futures contracts every month, and the problem is that you a) get lots of trading costs with this approach and b) the price of oil is usually in contango, which means that the spot or cash price of a commodity is lower than the forward price. So, if you keep buying one month out, and selling at spot you’re buying high and selling low continually. I suspect the people that buy this just haven’t read the prospectus. The numbers sold it to me, I pulled up a chart of USO and the price of oil, USO has historically underperformed oil due to its ‘buy high sell low strategy’.
I think it’s quite obvious that USO is going to zero. It may take a few years, but I believe that’s where it’s heading.
The TNA short is based on the same thesis. The ETF is triple leveraged, so it has to use derivatives to create daily leverage, it has to adjust the amount of leverage every single day. If markets go up, it has to increase leverage, if markets fall it has to decrease leverage, which exposes the fund to the same ‘buy high, sell low’ problem as USO. Eventually, this flawed strategy will push the price of the ETF down to zero. Overall, by shorting these two products, I’m able to maintain a short exposure without having to worry about the takeover or market over excitement risks usually associated with shorting stocks.
Nishkama runs both a long and short book. What traits do you look for when you’re evaluating potential short positions?
Unlike other investment managers that tend to focus on bad businesses, frauds and fads, we generally look at shorting stocks of decent companies, but where there is negative marginal change causing a shareholder transition. We short both “value traps” and “broken momentum” stocks. “Value traps” are primarily owned by value investors that we think can transition to deeper value or distressed holders. This usually occurs when the value investors realize that sustainable earnings power is lower than what they had thought. “Broken momentum” stocks are primarily owned by growth / momentum investors that we think will transition to value or GARP type holders over time. This transition can occur because of slowing growth, increasing competition, increased regulatory risk or for various other reasons. The disadvantage of avoiding frauds, fads and bad businesses on the short side is that we do not have shorts that go to zero. However, the offsetting advantages are numerous. First, we are playing in a less competitive area and have less borrow costs. Second, we have a natural factor balance in our portfolio, which reduces volatility. We are long and short decent quality companies. This balance can help in years (like so far in 2016) when low quality stocks significantly outperform high-quality stocks. We also have a style balance. We are long and short both value and growth stocks. Third, we can better leverage institutional knowledge that gets built up. When one shorts a fraud, fad or a bad business, one makes money or loses money and moves on. All of that financial modeling, building of relationships with management and industry experts, and company and industry-specific knowledge goes out the window. However, when one shorts a good quality business because of negative marginal change, one can potentially leverage all that work at some point down the road to go long that same stock when there is a positive marginal change that causes a shareholder transition to occur in reverse.
The basic strategy for our hedge fund is pretty straightforward. We look to own a portfolio of stocks that we think represent good value, and then we also look to shorting stocks or otherwise bet against a handful of stocks that we think are trading for prices far in excess of what we believe the underlying businesses are worth. On the long side, we are looking for the ingredients you’d expect from