Key Points: The Art of Short Selling -Kathryn F. Stanley

In the past few months, like many investors, I have been fascinated by the meteoric rise of NASDAQ and S&P 500 index amid the slump in U.S. economic activity. Companies like TSLA, which are popular among retail traders, have more than quadrupled in the past year and detach from reality. As market participant, the question is, how to benefit when the bubble pops. Shorting is not for the faint heart and many have been burned during the process. TSLA keep rising above $2000 per share after I thought it was peaking at $1600 level. Investors with tight capital will often have to buy in when margin called.

I picked up this book on short selling based on the recommendation of a friend who is an analyst on a buy-side firm. Despite being old, the book is full of valuable insight and case studies that are easy to grasp and applicable to today’s environment. Although our fund focus is on global macro, the book offers plenty of wisdom in a period when easy money lifts asset prices and swindlers are swarming the market.

The key points below serve as a reminder to me and the team when evaluating investment opportunities. I hope it is useful to you too.

“What’s the point?” we were asked, particularly by the money managers who had sworn off shorting. The point is that the toughest call for investors-even in a bull market-is when to sell. The best managers either sell stocks soon with a small loss, realizing a mistake, or sell stocks later, noting a change in prospect after gains, when prices begin to drop. Short-selling skills teach us the discipline of anxiety, of when to be scared.
A frequent criticism of short selling as an investment alternative states that stocks can go only to zero on the way down, but to infinity on the way up. Short sellers respond that they have seen a lot more stocks at zero than at infinity. Because they take greater risks than other investors, short sellers must be confident that their conclusions are correct, and they must have strong evidence to support cases for price declines. Because reverses are terrifying and sudden, the burden of evidence rests on a solid, careful analysis completed before the stock is shorted.
  stock prices reflect positive information more efficiently than negative information.”2 Large short-interest ratios, therefore, appear to be more bearish than the common wisdom predicts.
  negative-earnings surprises affect stock prices to a greater degree than positive-earnings surprises and that the effect persists over time.3 The common wisdom that there is no such thing as one bad quarter has a statistical basis. Robert Hagin coined the phrase “torpedo stocks” to describe the effect on a port-folio of a negative earnings surprise. “Stocks become torpedos when very high earnings expectations give way to earnings disappointments…. The higher one’s expectation for earnings growth, the deeper the disappointment if the expectation is not realized.”‘
  One theory suggests that fads linger in the security market because institutional investors are too averse to risk and too aware of short-term relative performance to bet against the fad and sell.
  Most brokerage stock recommendations range from buy to hold, with few analysts willing to rank stocks as sells. Analysts are constrained by corporate finance relationships or by their need to maintain communication channels with company executives.
  Short-sale candidates cluster in three broad categories: 1. Companies in which management lies to investors and obscures events that will affect earnings. 2. Companies that have tremendously inflated stock prices-prices that suggest a speculative bubble in company valuation. 3. Companies that will be affected in a significant way by changing external events.
  Clues that something is amiss in a corporation are the starting point of a short seller’s quest. These trail signs are grouped around several characteristics: • Accounting gimmickry: clues that the financial statements do not reflect the true state of corporate health. • Insider sleaze: signs that insiders consider the company a personal bank or think the stock should be sold. • Fad or bubble stock pricing: usually marked by a stellar price rise over a short period. • A gluttonous corporate appetite for cash. • Overvalued assets or an ugly balance sheet.
  A framework for stock analysis follows this rough outline: 1. Short sale analysis is dependent on financial analysis-cashflow pro formas, balance-sheet strength, and the quality of earnings. Start with at least two years of company financials and analyze the numbers by using the fundamentals of financial analysis: balance-sheet and rate-of-return ratios, income-statement analysis, cash-flow breakouts. Overlay traditional analysis with an especially tough look at quality of assets and earnings. Work from the IOQs and IOKs because these versions of the quarterly and annual reports that are filed with the Securities and Exchange Commission (SEC) have more data and less puff. 2. Use the proxy and the SEC insider filings to track management’s salary, stock activity, and attitude toward the company and its stockholders. 3. Check in the marketplace to see what the execution of the business strategy looks like-look at the products, the competitors, the suppliers of production inputs. 4. Follow the trading patterns, the short interest, and the ownership by watching price and volume, 13D filings (investor filings with the SEC when the investor attains a 5 percent or greater position), and institutional ownership. 5. Read anything in the media-magazines, newspapers-and the Wall Street research pool to determine consensus. 6. Watch everything about the company over time to see what happens, how earnings and price progress, what changes.
  The accounting-based analysis is not difficult to do, but it takes time, patience, and a suspension of belief. A Wall Street pundit recently commented that this level of fine-toothed work is too costly for brokerage analysts or institutional managers to perform because of the time and skill required. The lack of attention by other professional investors to these financial details provides the inefficiency in information dissemination that is so central to the short seller’s art.
  Short sellers are consistently years too early when they sell stocks. Stockholders are always slow to sell even when the evidence is irrefutable and the future for profit bleak.
  Short sellers fear most a sustained rally in a stock followed by a forced buy-in of their position, resulting in a loss out of their control. For that reason, short sellers tend to be secretive about positions in stocks with small floats (shares available for purchase, or outstanding shares minus insider and 5-percent positions), particularly in companies with floats below 10 million shares. Despite popular fears that short sellers band together to pound small companies into the ground, the reality is that a good idea is closely held by its originator. Any action that forces owners to sell can create a shortage of stock to borrow if the new owner takes delivery of the position. When short sellers go public with a stock-sale idea by communicating the story to the press and the stock has fewer than 10 million shares outstanding, they are betting on an immediate collapse to give them the opportunity to cover the borrowed shares at lower prices. Generally, however, publicity accompanied by only a slight downturn in price can create more problems for short sellers than it solves because the limelight might trigger buy-ins.
  Robertson feels valuation bets on price alone make bad short sales: There must be either a fundamental change in the outlook for the company or a major misconception by the stock-buying public.
  DiMenna shorts five types of situations: frauds, earnings disappointments, hyped stocks where he can shoot holes in Wall Street’s consensus expectations, industry themes where macroforces are negative, and deteriorating balance sheets. He reassesses short positions continually and, before he shorts, tries to determine the catalyst that will cause a stock to fall. He generally will not short stocks with strong relative strength and earnings momentum solely on the basis of overvaluation. Typically, he waits for these stocks to break before getting involved. He avoids short candidates in a crowded field unless the company is terminal.
  The Feshbachs looked for terminal shorts with these four characteristics: 1. Stock prices overvalued by at least two times Feshbach-per- ceived valuation. 2. A fundamental problem at the company. 3. A weak financial condition-working-capital problems or high long-term debt, for example. 4. Weak or crooked management.
  The Feshbachs do not short a stock unless they expect it to decline in price by 50 percent, because they believe that the risk of short selling is too great for marginal plays. “We short stocks where the negatives so overwhelm the positives that, over time, the market can’t just shrug off the bad news-eventually the stock price will reflect it,” Joe says.
  When they take a position, they typically add to it as more data come in, and they only cover because they made a mistake or because the stock hits the target price-not with a 20-percent decline for a quick profit.
  The Feshbachs feel that talking to competitors and suppliers reveals the climate and how long it might continue and gives insight into possible triggers. Joe Feshbach says, “You look for something that is obviously misperceived, obviously important, and obviously detrimental. At that point, if you’re comfortable that it’s already started to happen, that it’s not discounted in the price, and that it is substantial enough to get you to the price target, then you ought to get started.” He cautions that the first position is not necessarily the biggest because stocks go up and you want to be able to average up. But the time you really want to add to the position is when those factors become overwhelmingly apparent and the stock is still up.
  McBear is scorching in his contempt for Wall Street investment bankers who have shepherded their clients into breakneck acquisitions. He feels that part of the satisfaction of short selling is going against Wall Street. Corporate management is rarely the target, unless there is fraud. It is generally Wall Street that has engineered the ascent of the stock.
  Analytically, Chanos says he does not do anything that is very different from other managers, but his use of return on invested capital as a key financial indicator is unique. “‘Using this, we’ve been able to find companies that are not what they appeared to be.” His calculation is: earnings before interest and taxes divided by average total capital (which is defined as total liabilities plus equity minus current liabilities plus short-term debt or, to say it another way, the return on all interest-bearing liabilities plus equity plus deferred taxes and short-term debt). “That ratio will reveal a lot of wormy companies and poor businesses. It’s a tough number to screw around with.”
  perfect short-sale candidate is a stock with a large float to allow ease of borrowing and no buy-ins, a high stock price for maximum return, and no business or assets to keep the risk nominal and the investment horizon short-term.
  Reading IPO documents is a quick and lucrative exercise both for short sellers searching for silly valuations and for growth investors looking to avoid disaster. The biotech and high-tech new-issue markets of the 1990s were heavy going for the nonscientist seeking a sure loser; consumer products and bad business plans were easier to analyze.
  How soon will the new company run out of money? Shorts almost always judge correctly if the business is dying. On the timing of the demise, they are seldom right. Someone is usually available to buy stock, loan money, offer short-term bank debt long after the company financials are in nearly terminal condition. Add two years to a short’s best projection, and you might only have a couple more years to wait.
  with that massive receivables growth, sales could all come back in returned merchandise.
  Inventory and intangibles were, therefore, excellent places to stash costs that management might not want to expense on the income statement to reduce earnings in current quarters.
  The quality of earnings is a major issue with short sellers. Companies repeatedly try to include nonoperating earnings in “earnings” to create the appearance of growth and financial well-being. This subterfuge requires the analyst to read the footnotes and the management discussion of earnings in the 10Q.
  Jiffy Lube taught one bull-market lesson soon to be repeated in the 1990s: In the long run, it is the equity and the junk-bond holders who take the torpedo hit for poorly conceived business plans, not the insiders or the investment bankers.
  The patience required to track the trail of failure is a critical skill for short sellers avoiding the wrong stock or the wrong time in a growth company’s price trajectory.
  There is almost always a bell ringing on the growth stocks that have one product. Shorts get killed trusting their intuition and common sense; longs get killed with their belief that the company can always expand to one more market.
  Pipeline fill refers to the process of filling the distribution channels’ inventories: If the product is sold to the consumer from stores, the manufacturer must produce and deliver the product to every available store outlet. Pipeline fill on a new product rollout gathers momentum as more and more “doors” are opened; sales momentum crescendos as bigger and bigger accounts are added. At some point, the pipeline is full-every store has a shelf of product, and the growth rate is purely what the consumer consumes. So the revenue or top-line growth rate drops from huge to high teens or, even worse, single digits. That is the death of a growth stock. Thus, when Wal-Mart is full, the product is pretty much at the top of the growth curve. That is usually when a company starts talking international expansion, right before the end when they almost always enthuse on prospective sales in Russia and China.
  Store checks and valuation be damned, inventories are key in a one-product company rolling out in a new-era industry. If they build up, it is almost always because the product is not selling as planned.
  The shorts told growth stock players to worry if the product life cycle was shorter than the days of inventory on the balance sheet,
  when cash flow logically should be neutral and is massively negative, something stinks.
  The bigger point on cash appetite in a growth company is a concept called sustainable growth rate. It is an easy thing to remember and a killer ratio to track. Sustainable growth rate says that a company can grow at the rate of return on equity times the retention rate without going to the capital markets.
  That is also why a really high ROE makes for a lousy short sale-the company can finance its growth without caring a fig what the Wall Street pubahs think about the business plan.
  When a company switches or expands its business line into something completely different, it generally means management fears that growth will slow in the main line.
  The simplest form of financial obfuscation is detected by tracking the growth in receivables versus the growth in sales. Outsized growth leads the analyst to search out policies on booking revenues and collecting cash.
  The next level of complexity combines costs and revenues-the company manages earnings by delaying expenses and accelerating revenues. The asset side of the balance sheet rises as prepaid expenses build, and net income stays consistent, always upward by a comfortable growth rate. Companies that have perfect growth rates should always be carefully studied for gimmickry on the balance sheet-in particular, burgeoning prepaid expenses and deferred costs. Autotote had aspects of their financial statements that were intriguing to wrestle with, in particular incomprehensible assets and disappearing depreciation.
  Receivables can be up by more than sales for several reasons: 1. The company acquired a company, and the acquisition is not yet under control-collections do not have the same billing cycle or terms for sales, for example. If the acquisition was a large one relative to sales, the relationship of year versus year in receivables is not comparable. 2. The company is booking revenues too aggressively-for example, a three-year contract recognized at the front end, so that receivables stay high because the rate of payment is slow. 3. The company changed its credit policy to easier terms or is giving incentives for sales, thereby jeopardizing future sales. 4. The company is having trouble collecting from customers.
  Timely collections are sensible in a growing business because growth eats money by definition.
  Accumulated depreciation can drop for several reasons: (1) the company sells something or otherwise unloads property that is depreciated; (2) the company changes the life of the asset; (3) the company changes the salvage value. None of this information has to be disclosed, but it usually is. If the company unloads an asset, it generally shows up in the cash-flow-for-investment section; or, maybe, the gross property and equipment line might drop by a similar amount. When asked, company officials declined to comment. If TOTE, in fact, changed their depreciation schedule, earnings could have been massively inflated in the quarter.
  The accounting mumbo jumbo stocks should lead a stockholder to conclude: If you own it and cannot understand it, sell it. If you do not own it and cannot understand it, consider selling it short if you think the obscurity is just the tip of the iceberg.
  When a fundamental change occurs in the business environment, there are two strategies to follow for the short seller: short the marginal company or short the institutional favorite. Both strategies have proponents. The institutional favorite is the quality company with good growth, pretty financials, and a large number of institutional stockholders. Institutional favorites crash more quickly than marginal companies because large numbers of portfolio managers rush to dump the stock of the favorites when the analysts are finally convinced that the industry has been dealt an irreparable blow. If the company management is astute, they might dig their way out of the cave-in before the institutions exit. The marginal company, on the other hand, has shaky financials, bad management, and a history of aggressive but often poorly executed business strategies. Problems develop more rapidly when no support exists, either financial or managerial. The stockholder base is less sophisticated: They are slower to sell, they pay less attention, or, even worse, they are composed entirely of friends of the company. The price takes forever to reflect the reality of the company condition.
  Prepaid acquisition costs, remember, are costs that the company decided to defer expensing until later. They can be commissions paid to salespeople, costs of acquiring the business from another company, or costs of putting a partnership together. Integrated looked like it was attempting to manage earnings by deferring expenses. Not only does that not match cash flow (you pay now, collect later), but it puts future earnings in jeopardy. If revenues should slow (say, because the tax law changed), the company still has expenses to deduct every quarter, even without revenue-an interesting balance-sheet structure for a company in flux.
  The most important lesson from Integrated, one that should have been obvious (but perhaps not in the 1980s), was that banks and other short-term lenders (Drexel, in this case) control the destiny of a company that has negative cash flow. The lenders decided to foreclose. Nothing had changed with Integrated; the spigot was just shut off. Assets might be undervalued on the balance sheet, but if a company’s particular asset (be it a buggy whip or real estate) is illiquid when it needs funds, the asset does not count for much except as collateral for bonds or bank loans.
  The vision wars of the 1990s point firmly to the most prevalent mistake of short sellers: They are often shortsighted about the duration of hope for a new industry and for concomitant stock-price decreases. Stock-price parabolas can sometimes appear to bend back on themselves, but the rate of return on the short position might look like net income on a vision company in the interim. During a bull market, equity offerings, with an occasional convertible debenture, are the financing instrument of choice for the companies with no earnings that require great gulps of cash to shore up the day-to-day business of trying to make money some day.
  Three categories of opportunity appear in a bull market: (1) the restructured and heavily indebted company close to a stumble, (2) the “for sale” but not sold company, and (3) the company with deteriorating earnings that attempts to create the appearance of health with sale of assets.
  Part of the final price frenzy and unrelenting volume surge in a stock like Texas Air is that, toward the end of the parabolic price run, weak shorts get scared and cover and strong shorts run out of shorting room. The positions dwarf the usually well-diversified short portfolios, and managers short in smaller size, if at all. So there is unabated buying, with none of the balance or hesitation of the first part of the advance: white knuckle stuff. The shorts’ conclusion was that Parkinson’s Law of Short Selling should be: “The stock price expands to fill the available short capacity and last iota of patience, particularly when it’s a no-brainer.”
  when a major, industry-wrenching change occurs, money can be made by taking a position in a group of stocks clustered around a theme. Massive industry change can be triggered by macroeconomic events, by a specific product revolution, or by the death of a fad.
  Industry obsolescence can also be the flip side of Wall Street’s concept stock-a product change can sink a group of companies. When a tech toy, for example, becomes passe (like CB radios) or when a product is in less demand (higher oil prices sent recreational vehicle sales into a fishtail), any stock associated with those products is fair game for a collapse. Use a shotgun, not a rifle, for a sector bet.
  All it takes is an eye for trends because Wall Street turns like the Queen Elizabeth II: There is a whole lot of time to get firmly positioned before the first wave of downdraft, followed by the tell-me-it-ain’t-so bounce, sinks the stocks. Wall Street is much quicker to hype a new fad than to discard the old.
  They knew that buying a bank stock or an S&L stock was like buying a blind pool. Buyers never knew what they had, so the macroenvironment had better be right.
  The first and biggest reason for failure in stock selection on either the short side or the long side is too little work. Particularly treacherous on the short side, the absence of a carefully reasoned case can have painful consequences. Because short sellers, by their nature, cannot blame mistakes on analysts or friends or even assistants, analytical sloth is cause for the short equivalent of a hair shirt and mental flagellation. Usually, sloth is prompted by shorting someone else’s idea. If, in moments of greed for new ideas, short sellers short stocks without the normal painstaking file-building, spreadsheet-accumulating, brain-crunching work, the stocks will always go up quickly and scare the hell out of chastised short sellers. But they cannot admit, then, that they did not do the work, that they shorted without cause (an extreme violation of short principles, making them no better than longs). So they cover. As one hedge fund manager says, “Shorting’s easy. You short a stock, watch it double, cover in panic, then wait for the inevitable bankruptcy”-like
  Hubris is manifest in two primary analytical errors: (1) the sudden use of rigid formulas and (2) the short sale of good companies. The rigid-formula problem arises when short sellers start acting like Wall Street analysts and apply the same formula or spreadsheet or valuation methodology to a group of stocks without thinking.
  Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. If the stock is sold short simply because of valuation, the market immediately shows how high the earnings multiple can go. Buy index puts, instead; a valuation short is no different than a market bet. If the stock is shorted because of perceived temporary problems and because of excessive valuation, good management can fix the problems fast.
  Timing, the third major sin, is an error of judgment for which short sellers have no solution. It is what turns a profitable and monumental bankruptcy into a 2 percent annualized return because the seller was too visionary. The timing error is another one that scares novices into permanent T-bills. Because professional short sellers earn interest on short balances, they get paid to wait; most individuals do not have the luxury. The timing problem is the single biggest argument against individuals’ selling short-it throws off the risk/return relationships and suggests that individuals should use the discipline for selling or not owning stocks rather than for selling short.
  some short sales fail because the seller underestimated the ability of a leveraged company to grow its way out of the problem-to grow top line faster than the debt capitalization, for example. In the 1980s, when short sellers were first titillated by the leveraged-buy-out (LBO) balance sheet, they failed to realize how long debt takes to sink a company when the business environment is good.
  Sometimes, however, the presence of a large inventory of a commodity on a balance sheet can be a good clue that the company is either speculating rather than attending to business or has lost control of inventories.
  Short squeezes could be considered a market phenomenon rather than a short error, but they are, in fact, a self-inflicted wound. The float of a stock is of paramount importance for a short position.
  If a company gets hostile or aggressive toward short sellers, it can do two things: Write stockholders and ask them to take stock out of margin accounts and either put it into cash accounts or have it sent to them; or ask major institutional owners not to lend their stock. Indirectly, the company can also reduce the float by buying in stock for the company or the company retirement accounts or by placing large blocks in friendly hands. Some companies also use diversionary tactics like odd cash dividends and strange new shares of preferred or Class Z stock. Or the company can employ the most vicious defense: improve revenues and earnings.
  Short selling is the proper province of roller coaster afficionados. It works best for people who thrive on raw fear or masochism. Because most short sellers are inconsistent, even in their neurotic need for terror, most will panic at some point and cover a well-thought-out, rational position in fright. Everybody bolts sometime.
  When you cannot stand the pain anymore, buy something. It might make you feel better in the very short run. Or, even better, short more; if it scares you to death, it is probably the right move. The pain always continues for much longer than the pleasure. That is what makes short sellers different, and that is why the oldest living all-short professional seller is only 52 years old.
  Too many nouveau shorts are the bane of the pros’ positions. Inexperience makes a stock volatile, and it scares potential buyers away when the short seller is trying to initiate a position. A bunch of scared short sellers can create more pain and aggravation for the pros than the game is worth.
  The greatest mistake of all was being short during the strongest and longest bull market of the century.
  A corner was defined as a case in which short sellers were no longer able to borrow stock and were, therefore, compelled to buy it from the creator of the corner, who owned all available stock. Overextended short interest might result in a short squeeze and a subsequent rise in stock price; a short squeeze is not a corner, however, unless the available supply is held solely by one or two entities.
  words of Bernard Baruch, “No law can protect a man from his own errors. The main reason why money is lost in stock speculations is not because Wall Street is dishonest, but because so many people persist in thinking that you can make money without working for it and that the stock exchange is the place were this miracle can be per- formed.”
  One should start with the last dated balance sheet, looking for bogus assets or assets for which the market value is less than the balance-sheet value. Examples are: • Securities not marked to market. • Real estate at inflated values. • Inventories with obsolete products. • Receivables that have been booked too aggressively. • Receivables with loss provisions too low. • Bad loans. • Fuzzy, unbankable assets.
  Then accounts receivable and inventories should be tested by looking at the growth in receivables and inventories versus previous year and comparing that to the growth in sales and cost of goods. If the receivable growth is substantially greater than the growth in revenues, problems with earnings will be likely (unless, of course, an acquisition has reduced the numbers to noncomparable). (See National Education in Chapter 6.) The inventory indicator-growth in inventory versus growth in cost of goods-is the single most reliable sign that a manufacturer or retail company will stumble.
  A frequent area of abuse is deferred charges. A company that pushes expenses into the future can experience an earnings reversal if revenues dry up. Examples of deferred charges are prepaid advertising and deferred commissions or sales charges.
  Another category worthy of a jaundiced eye is goodwill and other intangible costs-potential clues that a company has overpaid for an acquisition or is failing to expense drilling costs or software development. Capitalizing routine expenses is another clue that a company is manipulating earnings. Capitalizing or deferring expenses like policy manuals and start-up costs might spread them over too long a period for the benefits of those expenses. Check the footnotes for exposition and see if the company discloses the schedule for expensing the policy manuals.
  Accumulated depreciation is a sleeper balance sheet line that nobody much watches. If accumulated depreciation drops when gross Property, Plant, and Equipment rises, the company might have changed the average life assumption and run the reversal through the income statement or might have simply reduced the depreciation expense in subsequent quarters
  The key points to remember about selling, short selling, or simply not buying are several: • Never assume that the same paradigm applies to all stocks. Each company and industry is different, so it is dumb to measure by the same scale if the yardstick is not relevant. If a company owns land at 1932 prices, do not worry about earnings or price/earnings. Think about the business and decide what the market wants you to pay for (cash flow, assets, earnings). Then, after thoughtful consideration of the prospects, value the company according to your own analysis. • Do not genuflect in front of a business, an executive, or an analyst. Keep your distance and your objectivity. The stock market is about people disagreeing over stock prices. Short sellers are entitled to their opinions, as are executives and analysts. And so are you. Do not take it seriously; it is only money. • A short seller is a skeptic with a constructive, optimistic bent. If you are appalled when an executive lies about earnings prospects, do not just sell the stock, consider shorting it. • When the short interest peaks at a staggering percentage of total volume and the lemmings embrace pessimism, remember that the stories of short-sale candidates are lessons in the antithesis of good company characteristics. Buying low and selling high is the game, no matter what the order of the transaction.

Published by Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.

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