Howdy! Welcome to issue #7. Sincere apologies because I usually try to have some variation and a number of topics in this newsletter. But I kind of just got stuck in a short-selling rabbit hole this week. But I promise Gamestop will not be mentioned!
As always, I’m keen to share what I’ve been reading, learning, and compressing.
Here’s the format of today’s email:
Part 1: What Makes a Good Short-seller? by Jim Chanos
Part 2: Russell Clark’s Short Selling Strategy
Part 3: Whitney Tilson’s Lessons From A Dozen Years Of Short Selling
Part 4: Jen Ross’ Guide to Shorting
Part 5: Under the Spotlight: Melanie Perkins
Part 6: Bonus Quirky Content - Something to Read, Watch, and Listen.
What Makes a Good Short-seller? [Link]
Short selling, so hot right now. But seriously, what makes a good short-seller? If you’re going to learn short selling from anyone, Jim Chanos would be the person for it.
1. Gumshoe fundamental research
For Chanos, the process for shorting is exactly the same as it is for a value investor looking to go long, except the reverse; excessive rather than cheap prices; crooked rather than straight management; ailing rather than sound business models
2. Resolute, brave independence
Not from the article, but I think Howard Mark’s thoughts on independence sum it up perfectly:
To do better than most, you have to depart from the crowd. All great investments begin in discomfort, since things everyone likes and feels good about are unlikely to be on the bargain counter. But to invest in things that are out of favour – at the risk of standing out from the crowd and appearing to have made a big mistake – takes confidence and resolve
3. A mind open to being wrong
Chanos regularly invites other Wall Street analysts to present their views on stocks that may be in conflict to his own (and no doubt also to convince them of his own views if he disagrees with them). Although comfortable with being an outsider holding opinions not widely shared, he doesn’t fall into the trap of thinking conventional wisdom is axiomatically wrong. Genuinely independent thinking should be based on wellreasoned, fact-based research and nothing more. Chanos knows that the popularity of a view, or its opposite, carries little weight.
4. A tolerance for financial pain
Short-sellers can make no more than 100%, (assuming no leverage), but potential losses are limitless. It’s a scary bet to make especially with clients money.
Good short-sellers have something in their DNA, or maybe we were dropped on our heads as babies.
5. An ability to work the media
To the activist short seller, getting media coverage isn’t just good public relations, it’s an essential part of risk management. There’s another aspect to Chanos’ famed media persona. The detective work necessary in finding a good short mirrors the work demanded of an investigative reporter. It’s possible that people like McLean see something of themselves in Jim Chanos, and vice versa. That makes for an enduring, trusting relationship that Chanos has leveraged to his advantage. Indeed, James Grant has said that Chanos would have made a good investigative reporter, ‘if only journalism paid as little as $25 million a year.
6. A tolerance for stress
“Short-sellers upset a lot of powerful, moneyed people”. Yeah, I can imagine that might be fairly stressful.
If you’d prefer to watch a video from Jim Chanos about his short selling be sure to check this out:
Russell Clark’s Short Selling Strategy [Link]
Short ideas tend to fall more erratically, with the first move lower being the most profitable. Being profitable at short selling requires the ability to pre-position in a stock before it moves lower, so timing is key. Momentum investing rarely works with short selling.
When Clark is deciding whether to short sell an industry, he uses a three-part process of Macro, Micro and Market factors. And will only short sell when all three parts are pointing towards an optimal moment to short sell.
Macro Factors
Clark looks for a change in trends in the macro-environment of either:
Currencies
Commodities
Interest rates and bonds
In particular, I focus on currencies, as they have a strong mean reversion bias. If we forecast significant currency weakness I can short sell exporters to those countries.
Typical signals of potential currency weakness include the following:
Large current account deficits
Negative net international investment positions
Large short foreign exchange positions within the financial system
Declining industries (ie falling oil prices, tend to weaken the currencies of major oil-exporting nations)
Micro Factors
What are individual companies are seeing and doing:
Excess capital expenditure
Regulatory changes
Increased competition
Most industries are cyclical. Cyclical tops are often caused by new entrants and excessive competition entering the market. A cyclical downturn typically ensues. Market returns can also be reduced by regulatory change, when governments seek to promote competition within an area.
Market factors
Once the Macro and Micro are in agreement, Clark then looks to Market-based signals to help determine when to short. Indicators to look for are following:
An unsupported bull market
Dispersion (particularly small caps underperforming large caps)
Overweight holdings in the market, and large ETF participation
Overall I highly recommend giving the full slideshow a read! [Link]
Whitney Tilson Lessons From A Dozen Years Of Short Selling [Link]
12 Reasons Not to Short (Excerpt from Chapter 11 of "More Mortgage Meltdown")
Shorting is not simply the opposite of long investing. It's much harder and more dangerous for a number of reasons:
Your upside is capped, and your downside is unlimited - precisely the opposite of long positions. When shorting stocks, you could be right 80% of the time, but the losses from the 20% of the time that you're wrong could exceed the accumulated profits. Worse yet, a once-a-century storm - such as the internet bubble - might wipe you out entirely. If there's even a 1% annual risk of such an event, that tiny risk translates into a 39.5% chance of the freak event occurring over 50 years.
To prevent such an occurrence, most short sellers use stop loss limits, meaning they will start covering the short if it runs against them a certain amount. This means short sellers not only have to be right about a stock, but also about the timing. If a stock rises significantly, many short sellers will lock in losses, even if they are later proven correct.
In order to short a stock, you first must get the borrow from your broker, who has the power to call in the stock you've borrowed at any time - or worse yet, buy stock to cover for you. Brokers are most likely to do these things if the stock is rising quickly, and they're probably doing it to other short sellers as well at the same time, so all of this buying pressure can cause a stock to rise even further, triggering even more covering. This vicious cycle is called a "short squeeze", and it isn't pretty - we can show you the scars on our backs.
Shorting has gotten much more competitive. There are now a few thousand hedge funds (and who knows how many individual investors) looking for the same handful of good shorts, in contrast to a few dozen a couple of decades ago. This results in "crowded" shorts, increasing the odds of a short squeeze.
A short squeeze can also be created if the "float" - the number of shares that trade freely - is suddenly reduced. Such a case occurred in October 2008 when Porsche, which owned 35% of Volkswagen, unexpectedly disclosed that it had raised its stake in Volkswagen to 74.1% through the use of derivatives. The German state of Lower Saxony, where Volkswagen is based, owns 20%, so that left a float of only about 5% of VW shares on the market. Three popular hedge fund trades had been to short VW based on weakening car demand, go long Porsche and short out its ownership of VW to "create" only Porsche, or go long VW preferred stock and short the common stock, betting on relative underperformance of the common. In any case, for whatever reason, nearly 13% of all VW common shares were short, so moments after Porsche announced its higher stake, the mother of all short squeezes ensued and the stock instantly quintupled from $200 to over $1,000, momentarily making VW the most valuable company in the world. This was extraordinarily painful for many shorts.
Short sellers used to earn interest on the cash they held while they were short a stock, but this has all but disappeared due to low interest rates - and brokers even charge "negative rebates" on hard-to-borrow stocks, meaning that short sellers have to pay 5%, 10%, 15% or more in annual interest to get the borrow.
The long-term upward trend of the market works against you (yes, believe it or not, markets used to go up most of the time).
Gains are taxed at the highest short-term rate.
It generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.
It's a short-term, high-stress, trading-oriented style of investing that requires constant oversight.
Mistakes hurt your portfolio more as they compound. If you make a mistake with a long position, it becomes a smaller percentage of your portfolio as it drops. A mistaken short, however, grows larger as it appreciates.
If you go public with your short thesis, a company can attack you in many ways: file a lawsuit (Fairfax example), complain to regulators (who occasionally investigate), tap your phone (Allied Capital example)
Einhorn predicted that Allied's stock would drop and shorted it at $26.25 a share. Over the next few years, as the stock climbed past $30, Einhorn tried to publicize Allied's misdeeds and became embroiled in a public battle that became the financial equivalent of Socrates vs. the Sophists. His wife was fired from her job at Barron's. An Allied official tried to steal his phone records. The SEC investigated him in addition to his target.
Also, expect to get flamed on message boards and in the media. Many people view short selling as evil and un-American.
10 Reasons to Short
If you're very good at it, you can make money over time.
Having a short book allows me to invest more aggressively on the long side, both in terms of overall portfolio positioning, individual position sizes, and willingness to take risks in certain stocks. Here are some examples:
I wouldn't be comfortable taking my fund's long exposure up to 100% in the current market if it didn't have meaningful short exposure;
I wouldn't have held onto my position in Netflix as it rose from just above $50 to nearly $500 over the past two years if my fund hadn't been short a number of similarly volatile, speculative stocks;I wouldn't hold such a large position in Howard Hughes, another huge winner for us, if my fund weren't short St. Joe, which is also closely tied to the real estate/housing market; and
I'm not sure I would feel comfortable owning economically sensitive stocks like Tetragon, Avis and Hertz, four airline stocks, etc. if my fund weren't short many stocks that I expect would do very poorly if the economy weakens.
A short book typically pays off just when you need it most, during severe market declines, providing cash - and the psychological boost - to invest aggressively on the long side when it's most attractive. It also stems investor redemptions, which is effectively another source of cash.
This is exactly what happened to me in 2008 and early 2009. After inflicting losses as the market rose from early 2003 through October 2007 (the same length of time as the current bull market), my substantial short book cushioned the downturn - my fund was down approximately half the market in 2008 - and allowed me to invest aggressively on the long side, which translated into big gains after the market bottomed in March 2009.
I sleep better at night with insurance. At the beginning of every year, I write a check for homeowner's insurance, and at the end of the year, when my apartment hasn't suffered from a flood or fire, my insurance expires worthless and I have to buy it again. Is it a mistake to buy insurance that turns out to be worthless almost every year? Of course not.
There are far more good short ideas than long ones at most times, as there are large forces pumping stocks up, not down.
The psychic rewards are enormous:
Shorting is much more contrarian than buying an out-of-favor stock.
It's incredibly interesting and entertaining, thanks to the preposterous lies and incredible cast of promoters, charlatans, and crooks you encounter.
It feels good to bet against these cretins.
For all these reasons, making $1 on the short side is 5-10x more gratifying than making $1 on the long side.
Developing the mindset of a short seller has been very valuable: extreme skepticism, knowing where to look for bombs on a balance sheet, etc.
It puts me in the flow of short ideas, so I often hear/read about problems with companies whose stocks I'm long (or considering going long), which has saved me from some blowups/value traps.
It keeps me occupied so I don't do stupid things with my long book like sell a winner, or get impatient and sell a stock right before it jumps.
Most investors expect hedge funds to have a short book. *Kalani’s Note: I don’t particularly understand and support this reason, but what do I know"*
Jen Ross’ Shorting Guide
Jen Ross (@rocket_jenross) has produced a goldmine of short-selling information. And it’s hidden in Twitter comments! Might be up there for one of my favourite obscure finds on Twitter. That is, of course, unless I’m super late to the party and more people know about this than I thought.
Qualitative Signs of Fraudulent Companies
No cars in the parking lot; Ferraris in the parking lot
"No paint on clothing" (using props)
Fancy art and fountains at new Headquarters
Extravagant suits on CEO or CFO
HQ outside of US; HQ in difficult locations to visit (e.g. military base)
HQ in Nevada or Florida
Corporate plane in exotic locations where the business is not being conducted
Company name on a stadium Uses no-name auditor
Repeat offenders; "youthful indiscretions" 4 check-kiting & grand theft at age 30
Erratic behavior of CEO or CFO towards investors on earnings calls
Obsession with short-sellers
Husband-wife management team or family executives/Board members
Aggressive micro-expressions during one-on-one meetings
IPOs with a no-name bank Immature behavior on social media
Fraud - Qualitative Indicators
In Seven Signs of Ethical Collapse, Marianne M. Jennings examines why good people at great companies cross "very bright lines" and do dumb, unethical things. Her seven signs:
Pressure to maintain numbers
Fear and silence
Young 'uns and a bigger-than-life CEO
Weak board of directors
Conflicts of interest overlooked or unaddressed
Innovation like no other company
Goodness in some areas atones for evil in others
Techniques of Fraud Schemes
Improper revenue recognition - Stuffing the channel, shipping of unfinished product, booking of fictitious sales, roundtripping, buy and hold
Capitalizing software before technological feasibility
Capitalizing R&D costs
Changing method for calculating warranty periods or gift card breakages
Changing the appropriate allowance required for uncollectible accounts receivable
"Big Bath" charges
Creative acquisition accounting
"Cookie jar" liability reserves
Use of materiality to record small but intentional misstatements
Note: Not all of these gimmicks ore in violation of GAAP.
Warning Signs on the Financial Statements
Pro tip: Always read the footnotes in the 10-Q and 10-K
Revenues are growing from acquisitions, but not organically
Income statement shows a net profit or EBITDA is positive, but cash flow is negative
Manipulation of working capital. E.g. Accounts receivables clays are growing; revenues are not being collected, Accounts payable days are growing; vendors are not gelling paid, Inventory is mostly finished goods
Capitalizing software or R&D
Recurring non-recurring charges
Use of Non-GAAP or "Adjusted" numbers on press release rather than GAAP
Related party transactions
Off-balance sheet liabilities
Operating profit cannot pay interest expense
EBITDA cannot cover interest and capital expenditures
Tangible book value is negative or mostly goodwill and intangibles from an acquisition
Large debt payments coming due
Unfunded pension liabilities
Going concern language
Re-statements
Risk Mitigation When Shorting
After quarterly reporting, has anything fundamentally changed?
New products or services?
Running the business more efficiently?
New management?
Manage position size; stick to your rules Keep "dry powder" Review case study • Am I just wrong? Check your ego and emotion • Is the stock trading on something other than fundamentals • ESG ("socially responsible•) investing, Beyond Meat, Nerflix
Categories of Shorts
Buggy whip: Companies unable to adapt to change. E.g. Yellow pages, Kodak, JC Penney's.
Poorly managed: Management team is a better indicator than financials; a good team can turn a company around.
Bubble: "Cloud," SAAS, alternative fuels, healthcare...space
Just a stupid business: Talks about total addressable market, uses phrases like "the Uber of X”.
Fraud: By far the most fun; however, the riskiest type of short. They can stay fraudy longer than you can stay solvent.
Miscellaneous Tips
Do not assume someone else already checked.
Do not assume other people are smarter than you.
There is no shame in asking a question — the "dumb" question is sometimes the smartest (The Emperor Has No Clothes).
Trust your instincts; if something does not seem right look deeper.
Don't let people hide behind platitudes, superstitions & excuses. E.g. "it's a trade secret," answering a different question than the one you asked, hue but irrelevant statements.
Do your own research. Avoid groupthink; know & understand the Bull Case. Television talking heads & investment bank research is not trustworthy.
Under the Spotlight: Melanie Perkins
Each week I provide a little spotlight on an investor or operator I admire.
Melanie Perkins is this weeks focus, in a nutshell:
Born in Perth, Western Australia (My hometown!). Her mother of a teacher, and her father an engineer.
Started her first business venture at 14 making and selling handmade scarves at Perth markets and shops.
Later on, she was a private tutor for students learning graphic designs, while studying at UWA. From this tutoring, she noticed difficulties in students learning design programs. She thought there could be a business opportunity in making the design process easier to learn and use.
Today Canva has helped create close to 2 billion designs in 190 countries., and Perkins is one of the youngest CEO’s of a tech start-up valued over $1 billion dollars.
This Week in Startups [Apple Link]
Gives a great background of the story of Canva and her life. Also, I really rate Melanie’s view of trust and transparency:
One thing that’s really critical as a founder, we try to always undersell numbers so we round down if we have a number. It is really critical to make sure that truth is a very very strict line in the sand and you don’t ever cross that.
Managing expectations is a different kettle of fish because you are needing to get people to understand your vision and what you’re trying to do and achieve. But it’s also critical for people to know where you are today, and not to be shifty with that one.
Canva Uncovered: How A Young Australian Kitesurfer Built A $3.2 Billion (Profitable!) Startup Phenom [Link]
Staying down to earth. Love it.
In an era of billion-dollar checks from SoftBank and high-profile profligacy at WeWork, Perkins and Obrecht do things differently. They are couch surfers who prefer budget trips to private jets. (This summer, with Canva already valued at more than $2 billion, Obrecht proposed to Perkins in Turkey’s backpacker-friendly Cappadocia region with a $30 engagement ring.)
My sincere apologies that this weeks spotlight is a bit shorter. Been flat out and haven’t managed to catch up!
Bonus Quirky Content
Something to read: Interviewing Principles [Link]
Prepare carefully, familiarizing yourself with as much background as possible.
Establish a relationship with the source conducive to obtaining information.
Ask questions that are relevant to the source and that induce the source to talk.
Listen and watch attentively.
Do not be afraid to ask naive questions. The subject understands that you do not know everything. Even if you have done your homework there are bound to be items you are unfamiliar with. The source usually will be glad to fill in the gaps.
h/t to Terminal Value (@valueterminal) for this one! Remember seeing it shared a while back.
Also, if you’ve managed to read this far down, now is as good a time as ever to say I’m in the works of putting a podcast together! (Still working on a name for it and a targeted niche, I just want to interview interesting people!) ¯\_(ツ)_/¯ Aiming to release weekly by May. But early days still. Feel free to reach out with any questions, ideas, or advice!
Something to watch: How Starting a Blog Will Change Your Life
It’ll force you to make better decisions by clarifying them when writing.
It’ll make you more attractive to work with because it’ll show a portfolio of your work.
Lets you build an audience. Helps you find your 1000 true fans.
You might make money from it.
You’ll make great friends. Posting online is magnet to attracting people with similar goals and tastes.
There’s always room for great content. No one can compete on you being you.
Something to listen to: Michael Phelps and Grant Hackett on Tim Ferriss [Apple Link]
Two absolute champions of swimming. They’re on this whole other level to us mere mortals. They do amazing things by doing things we won’t. The below quote from Phelps sums it up perfectly. You have to be willing to try, experiment and grind out that extra 1%. And while 1% may not sound like much, it all adds up.
Trying to do something that no one’s ever done before, you really have to approach it in every single different way possible than ever has been done before. There is no blueprint for it.
Also, imagine having the balls to tell an elite athlete to slow down and take it easy lmao.
Grant Hackett: I always had people tell me, “Oh, Grant just slow down, just enjoy it, just relax. Don’t don’t try and do everything to the top level every single time.”
Michael Phelps: I hate when people say that shit. God, it pisses me off so much.
Grant Hackett: I tried that, and you know what I realized? That’s not me. Like doing things mediocre is not me. I can’t stand that. And it was funny, all the things that disconnected with my value set destabilized me. And so I focus on reading things, reading journals, doing things that connect more with me and those things like mental toughness, reading about Navy SEALs, reading about different training strategies, that sort of stuff I really love. And I find that an escape from my personality. So that’s quite a good thing.
Until next Wednesday, have a good one!
- Kalani
You can find previous issues of Curated by Kalani here. I’m on the web at kscarrott.com and on Twitter @scarrottkalani.
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Super in depth and fascinating article Kalani, thanks for this! – Nicole