Short Selling Read online

  Now, if the market expects the EPS to double every year for the next three years, would the market still pay a P/E multiple of 10? In this case, the company will earn $4, $8, and $16 or a total of $28 over the next three years (higher than the current stock price). If most earnings flow to their cash balance (remember that companies report earnings on an accrual basis, not on a cash basis), they can theoretically go private by buying back all their shares in 2.5 years.

  In general, low P/E indicates that the market expects a lower earnings level, and high P/E indicates that the market expects growth in earnings. The P/E for a company with growth expectations will be much higher than 10 and can reach ridiculous levels (100 to 500), depending on hype and the market sentiment.

  It is important to understand the drivers of sustainable growth (total addressable market for the product, unique features of the product, competitive dynamics, product shelf life, time needed for a competitor to design and bring alternative or competitive products to the market) and clear reasons or catalysts that could derail the growth trajectory. It is not a good idea to short a company with open-ended growth that is hard to estimate. Such shorts are more often wrong than right.

  During the dot-com bubble of the late 1990s, companies with no history of sales traded on multiples of hope, and it seemed that the valuation methods for traditional industries did not apply to the new-world technology companies. Even technology companies with demonstrable sales, such as Cisco, traded at insane multiples. Enterprise value to sales or price to sales are the most commonly used valuation metrics for fast-growing technology companies.

  In July 1998, Cisco reported annual revenues of $8.5 billion—30 percent higher than the prior year due to increasing unit sales of high-end switches—and the stock traded close to 10× sales for a market cap of approximately $85 billion. A year later in July 1999, Cisco reported a 40 percent increase in sales to $12.1 billion, and it traded at approximately 20× sales for a market cap of approximately $210 billion.4 In July 1999, did Cisco’s valuation seem extended, projecting sales to continue growing at 40 percent for many years? Maybe, but Cisco’s performance over the next year demonstrated the dangers of shorting based on valuation alone (figure 1.1).

  In July 2000, Cisco reported a 60 percent increase in sales to $19 billion from continued growth in switches and routers sales. Cisco was now trading close to 25× sales for a market cap of more than $450 billion. In terms of P/E, Cisco was trading at a P/E of approximately 200, up from a P/E of 90 in 1999. A short trade at a P/S of 20 or a P/E of 90 would have resulted in a negative 110 percent return, and a concentrated short bet on Cisco could have destroyed the investor’s portfolio. As John Maynard Keynes is often quoted as having said, “Markets can remain irrational longer than you can remain solvent.” Keynes, like Ben Graham, suffered a huge blow to his investments during the 1929 crash; his quote is a stark reminder that capital misallocation can lead to disastrous portfolio returns.

  FIGURE 1.1 Cisco revenues, stock price, P/S 1998–2001. Source: Cisco SEC filings.

  Hindsight is 20/20. It is easy to see why it would have been wise to sell Cisco at a P/S of 25 in 2000 and not at 20 in 1999. When Cisco’s revenues were growing 40 to 50 percent annually, it was hard to estimate addressable market for switches and routers; it was also hard to predict whether Cisco would remain the technology leader in the market. Cisco’s gross margins could also have kept growing with operating scale. Frequent merger and acquisition (M&A) transactions could further confound Cisco’s growth estimates. If we had a crystal ball to predict market size, it would still be impossible to guess the most insane multiple that the market would be willing to pay for Cisco stock.

  The Cisco story illustrates the typical timing difficulty in shorting growth or high valuation stocks. Nonetheless, if we can spot flaws in the business model of such companies or identify catalysts that can permanently hurt their growth prospects, high valuation can be a good starting point to look for short ideas.

  Takeaway

  Shorting expensive stocks based only on valuation is dangerous.

  Researching the Short Idea Requires the Same Fundamental Skills as Those for Longs

  Fundamental research can uncover flaws with business models. Fundamental analysis for possible short positions is not different from that for long positions, which involves understanding business models, analyzing financial statements, identifying growth drivers of business and industry, valuing businesses, evaluating downside risks, and finding an edge on the investment thesis.

  Such investment classics as Security Analysis by Ben Graham, Essays of Warren Buffett, and Common Stocks and Uncommon Profits by Phil Fisher provide excellent frameworks for fundamental analysis of businesses and lend insight into the minds of successful value investors. Similarly, One Up on Wall Street by Peter Lynch and investment letters from growth investors provide frameworks (e.g., sizing the market, analyzing ongoing trends, and growth potential for new products) to analyze compounders or growth companies and find conviction in their growth prospects.

  It is important to understand the reinvestment economics of a company to identify the levers of growth. Companies in growth markets tend to invest in product research and development, distribution capacity (e.g., stores, warehouses), manufacturing capacity, brand marketing, or sales force expansion. Each of these investments allows a company to increase or capture market share; however, such reinvestments in the business may not necessarily result in profitable growth.

  It is critical to look at the following seven aspects of any business, which is by no means an exhaustive list but is a good checklist for fundamental analysis.

  Checklist for Fundamental Analysis

  1. Industry: Market size, market concentration (top-five market share), competition, nature of the industry (capital intensity, seasonality, etc.), stage of the industry (nascent, mature, etc.), signs of cyclical or structural changes in the industry

  2. Product: Unique features and competitiveness, research and development investments, marketing investments, scalability, customer captivity, switching cost, substitutes, product moats (patent protection, regulatory barriers, etc.)

  3. Financial statements analysis and valuation:

  (a) Mature businesses

  Income statement: Revenue drivers, fixed and variable costs, last ten-year earnings before interest and taxes (EBIT)/operating margins, net income, and returns on equity/capital, quality of earnings, and cyclicality/seasonality in the business

  Balance sheet: Investment asset quality and liquidity, leverage and covenants, balance sheet line items (inventory/working capital, etc.)

  Cash flows: Reasons behind convergence/divergence from earnings, capital expenditures (Capex), and financing

  (b) New businesses: Drivers of revenue and earnings growth, sources and usage of cash, and cash burn rate, plus any additional relevant metrics mentioned for mature businesses above, where available

  (c) Valuation: Relevant valuation multiple for the industry, such as price to book, P/E, price to sales (P/S), enterprise value to sales (EV/sales), enterprise value to EBIT (EV/EBIT), EV/(EBITDA − Capex), net asset value, discounted cash flow, free float, free funds flow, and free cash flow multiples, etc.

  4. Customers: Export versus domestic sales percent of revenue, customer concentration (customers with >5–10 percent of revenue), company’s position and competitive strength in the industry value chain

  5. Management team: History of execution, shareholder value creation, capital allocation, reputation, ethics, insider ownership and executive compensation, recent insider transactions

  6. Economic cycle of the business: Current economic state, cyclicality, seasonality, growth cycle, current growth stage, monetary cycles, and currency movements

  7. Near-term and long-term threats: Legal, product cycle/substitutes, competition, regulatory/sovereign risk, structural changes in business model, patent expirations, waning product demand

  Structural Shorts, Tactical Shorts, and
Paired Shorts

  Before digging into the due diligence process behind short ideas, let me classify shorts into three categories with different investment horizons: (1) structural shorts, with a one- to two-year outlook; (2) tactical shorts, with a one-week to one-quarter outlook; and (3) paired shorts, where investors hedge longs with temporary shorts on the stock’s competitors, vendors, clients, etc. The due diligence process for each of these categories is not equally rigorous.

  In general, a successful structural short thesis can point at cracks in the business model, structural changes in the industry, financial shenanigans, changing competitive landscape, abnormally high valuations, peak operating margins, and most importantly, multiple impending short-term negative catalysts. I would also include cyclical shorts in this category because most long-term issues appear to be cyclical issues first and eventually become chronic.

  Tactical shorts are typically short-term trades based purely on speculation, momentum (short a falling stock ex-post negative news), and sympathy trades (e.g., speculation on a slowdown in the luxury segment after negative news from a luxury brand and short other stocks in the luxury-brand sector). Some high-frequency trading firms also use proprietary quantitative strategies to short stocks and hold short positions anywhere between a few milliseconds to a full day. I will not cover tactical shorting based on technical or quantitative analysis or chart reading beyond the concept of peak-to-trough corrections.

  Paired shorts, as the name suggests, are combinations of long and short trades, such as short Boeing and long EADS (two companies in the same industry) or short Corning and long Best Buy (short supplier and long customer). Generally, the motivation behind pair trades is to hedge systemic risks of long trades; such short trades tend to be sloppy and not as well researched as their long counterparts. Analysts can source such short ideas from a headline on a short thesis from a newspaper, a friend, Wall Street, and even their shoe shiner, among other sources.

  In this chapter, I focus on the due diligence process to find structural shorts based on the analysis of public filings and earnings or presentation transcripts. The analysis is focused on issues with their business model, such as declining demand for products and services, emergence of new product substitutes, rising input costs, threats from alternative distribution channels, declining profitability, and competitive pressure. As these issues evolve, investors try to find an edge through primary research before the issues find wider coverage in newspapers and other media.

  Analysts rely on scuttlebutt (Phil Fisher popularized this approach), channel checks, proprietary surveys, field trips, management interviews, idea dinners, and the like to improve their informational advantage on short ideas. However, some of these research tools can be resource intensive, expensive, and more suited for tactical shorting based on estimating the next quarterly sales, earnings, or cash flow.

  Takeaway

  Structural shorts are longer-term shorts on companies with structural issues with their business or business model. Tactical shorts focus on shorter-term issues and rely on scuttlebutt, surveys, and channel checks.

  Why Do Stocks Fall?

  Let us take a look into some key reasons behind negative stock price action and related stories. Some of these events and reasons can prove to be prognostic indicators for a short thesis. None of these may be reason alone to buy or short a stock, and there is no shortcut to fundamental research for higher conviction in short ideas. Sourcing short ideas is hard even for veteran short sellers. The following catalysts covered within the short-selling framework can help source and vet short ideas.

  Investigations: Internal or Regulatory

  Internal or regulatory investigation announcements are almost always a negative surprise for the stock, especially if the investigations are announced on the heels of an already announced negative news item or accusation against the company. Obviously, such investigations cannot be predicted; however, the odds of an investigation increase dramatically if a reputed news source, investor, or analyst presents compelling evidence of an accounting misrepresentation or unethical business practice.

  Typically, when such news breaks, the stock turns into a hot stock, gyrating for a few days and igniting a tug of war between bulls and bears. This may not be the best time to place a short trade, but it is a good time to research the stock to identify knock-on effects and other negative catalysts and related downside risk to the current valuation. In such a case, rich valuation may serve as icing on the cake.

  SHORT-SELLING FRAMEWORK: WHAT TO LOOK FOR

  1. Structural shorts

  a. Unsustainable leveraged business model

  i. Threat of covenant breach, credit rating downgrade

  ii. Decline in the value of assets financed by debt

  iii. Declining same-store sales, long-term operating leases

  iv. Heavy dependence on financing, tightening credit cycle

  b. Business model issues

  i. Loss of key client, product, executive, or subsidies

  ii. Industry on a secular or cyclical declining trend

  iii. Signs of market share loss and threat to profit margins

  iv. Declining prices, rising raw material cost, or both

  v. Government investigation of business practices, fraud

  vi. Mergers and acquisitions that kick issues down the road, expensive acquisitions

  vii. Exiting high-margin business or entering low-margin business resulting in a lower operating margin profile

  c. Value traps: Stocks that may seem cheap on certain metrics, but in reality may not have moats to protect their business and may face long-term chronic issues

  d. Broken growth stories: Strong competition, rival products from competitors or customers, products going out of fashion

  e. Financial statement issues and shenanigans

  2. Tactical shorts

  a. Signs of macroeconomic issues and recession

  b. Successful investor announces a short position

  c. Initial public offering (IPO) lockup expiring, key investors exiting, insiders selling

  3. Paired shorts: Short competitor or customer to hedge long position

  In April 2011, Diamond Foods (DMND) announced a deal of approximately $2.4 billion to buy Pringles from P&G, including $1.5 billion in Diamond stock. Diamond had a market cap of approximately $1.3 billion, and this transformative deal would have doubled their 2011 sales. Six months later, The Wall Street Journal pointed out that Diamond had inflated their 2011 earnings by making a momentum payment to its walnut growers in September instead of July (the last month of their fiscal year). Diamond stock retreated from its all-time high as some noted short sellers began to point at serious flaws (see chapter 4) in Diamond’s walnut business that could lower Diamond’s gross margins and potentially threaten the Pringles deal.

  After the news, Diamond was still trading at a rich valuation of a P/E of approximately 50 (standalone Diamond earnings) and a P/E of approximately 30, including the Pringles earnings. Diamond stock corrected approximately 17 percent from its high of $92 by mid-October after the Wall Street Journal article. On November 1, Diamond announced an internal investigation into the alleged accounting irregularity, resulting in a delay in closing the Pringles deal. The stock fell approximately 18 percent on the announcement.

  On November 22, the death of a Diamond director who had recused himself from the internal investigation was reported as a suicide; Diamond stock plunged even further, by approximately 20 percent. The Securities and Exchange Commission (SEC) opened an investigation into the alleged irregularities. However, the Pringles deal was still on the table and the stock recovered approximately 35 percent to $37 by February 8, 2012.

  On February 9, Diamond fired the chief executive officer (CEO) and chief financial officer after their initial internal investigation. Diamond stock dove 37 percent on the news because the chances of a Pringle deal now appeared slim. On February 15, Kellogg announced a deal to buy Pringles, ending all speculation o
n the deal. Diamond stock subsequently fell another ~40 percent to $13 by November 19, 2012, as the company restated financials and struggled to repair its reputation.

  In general, it is important to pay attention to investigations announced by the company or government regulatory agencies such as the Department of Justice, the Attorney General, the Federal Communications Commission, and the Federal Trade Commission. The announcements can sometimes lead to good short ideas, especially if the stock is trading at rich valuation multiples.

  Investor Announcements and Insider Transactions

  The market pays close attention to stock transactions by both outsiders (institutional investors and money managers) and insiders (company executives). Certain firms specialize in spotting unusual trends in such transactions, such as when key investors in a firm disclose significant increases or decreases in their stake, mostly by quietly filing a Form 13 (F/D/H, etc.).

  Executives or insiders can disclose their stakes through a Form 4 filing, or planned stock sales through Form 10b5 filings. Unusual or heavy insider selling can signal that insiders are aware of negative news that is unknown to the broader market. On December 10, 2012, The Wall Street Journal reported an insider-trading probe launched by Manhattan’s Attorney General into cases where company executives sold their stocks (under 10b5 plan in many cases) prior to the announcement of material negative news.