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Lessons From a Dozen Years of Short Selling

 

Columbia Business School Presentation – Whitney Tilson

Whitney Tilson, founder and Managing Partner of Kase Capital Management, shared his thoughts on short selling at the Columbia Business School in November 2015.

12 Reasons Not to Short

  1. 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.
  2. 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.
  3. 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.
  4. Shorting has gotten much more competitive. There are now a few thousand hedge funds 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.
  5. 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 VW to 74.1% through the use of derivatives. The German state of Lower Saxony, where VW 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, 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.
  6. 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.
  7. The long-term upward trend of the market works against you.
  8. Gains are taxed at the highest, short-term rate.
  9. It generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.
  10. It’s a short-term, high-stress, trading-oriented style of investing that requires constant oversight.
  11. 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.
  12. If you go public with your short thesis, a company can attack you in many ways: file a lawsuit (Fairfax), complain to regulators (who occasionally investigate) (MBIA, Farmer Mac), tap your phone (Allied Capital), etc. Also, expect to get flamed on message boards and in the media. Many people view short selling as evil and un-American.

9 Reasons to Short

  1. If you’re very good at it, you can make money over time.
  2. 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
  3. 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.
  4. 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.
  5. 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 characters you encounter – shysters, crooks, charlatans, promoters, etc.
  • 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
  1. Developing the mindset of a short seller has been very valuable: extreme skepticism, knowing where to look for bombs on the balance sheet, etc.
  2. 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.
  3. 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.
  4. Most investors expect hedge funds to have a short book.

Sources of Good Short Ideas

  • Other short sellers: build relationships and networks, and swap ideas
  • Attend investing conferences
  • Value Investor Insight
  • ValueInvestorsClub.com
  • Activist Shorts Research
  • Seeking Alpha
  • SumZero
  • Citronresearch.com
  • Stock screens
  • Newspapers, magazines, business television

Other Tips

  • Try to match long and short positions
  • Stocks usually follow earnings
  • Beware of the “Beat N’ Raise” Game (examples: Netflix, Facebook, salesforce.com, Priceline)
  • Be patient (examples: Lehman Brothers, Crocs)
  • Look for “Titanics” (examples: Lumber Liquidators, Exact Sciences, Herbalife, World Acceptance)
  • Look for obvious bubbles (examples: 3D printing, alternative power promotions, SaaS/Internet, Biotech/Pharma)

Conclusion

  • Shorting is a very difficult business
  • Size positions small
  • Balance long and short book
  • Be patient
  • Look for multiple ways to win: very high valuation; very high margins; fad coming to an end; market under-reacts to earnings miss/guide down, regulatory action, etc.; impact of new competitors; regulatory problems
Image Source: CNBC

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