Short Selling: Learning from Others’ Mistakes


Mitigating Short Exposure: Learning from Others’ Mistakes

As a follow-up to a summary on Whitney Tilson’s Columbia Business School Presentation: Lessons From a Dozen Years of Short Selling, below is a summary of CFA Institute blog’s compilation of helpful insights from well-known bears and long/short portfolio managers on how to size shorts, manage risk, and avoid margins calls.

Size Them Small

  • Due to inherent risk asymmetry, short position demands more frequent maintenance than a buy-and-hold investment
  • Most prolific short sellers like Jim Chanos, John Hempton, Kyle Bass, and Anthony Bozza preach the same gospel: open shorts no larger than a 2% to 3% position and be prepared to cover over 5%
    • Stress of managing a short of this size or more will strain your financial capital as margin may not be free and will strain your mental capital as well
    • “Domestically we have 50 names. Typically no one position will ever be more than 3% or 4% of the portfolio” – Jim Chanos
    • “We size our positions between 5% max and min 0.5%. Whenever a position gets too big, we reduce it to keep it in line with the intended % of capital amount” – Jim Chanos
    • “There is a reason why our shorts are numerous and small. When you get one wrong it really hurts. So far we have not had too many errors but it will not always be that way. Solution: Do 50 plus – all small – and then one bad one is not going to matter. The losses of 4.5 times your initial investment is a real short disaster, but if your initial position is 1% – and you lose it over two years it hardly matters” – John Hempton
    • “Never set yourself up for the knockout punch” – Kyle Bass
  • Leave money on the table every single time, concentrate your focus and your funds on the long side where risk is limited to just the capital deployed

Pay Attention to Leverage

  • Common investor mistake on both the long and short side is to focus on market cap while ignoring enterprise value; this is far more dangerous on the short side for obvious reasons
  • If you are short a levered equity and business inflects higher, you can lose multiples of your invested capital
    • Happens most often in oil and gas and basic material stocks – businesses that often have the combination of high operating costs and financial leverage
  • “If you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock price only wipes out 5% of the total capitalization. You have to look at the total capitalization. In some of these cases the total capitalization is only down a little while cash flow has been cut by 75%. This is the reason some investors get killed in value traps. They look at the stock and they don’t look at the total capitalization. They don’t realize that the debt burden is forever, meaning it’s not shrinking, whereas the equity capitalization may fluctuate in the market. If the cash flows have diminished dramatically the company’s ability to service the debt, then the stock going down by half doesn’t mean anything. You could still be at risk of losing all your capital” – Jim Chanos

Never Go Net Short

  • Two undisputable market truths:
    • The US stock market has risen over time
    • The Wall Street sausage machine exists to push stocks higher
  • “In practice, we have more long exposure than short exposure because our shorts tend to have greater market sensitivity and volatility than our longs. Also, the market tends to rise over time and we wish to participate” – David Einhorn
  • “I think making money on the long side is a more fruitful activity, but from a portfolio-management standpoint, the shorts give you the staying power to live through difficult market conditions. In a perfect world, you should be able to make money on both your longs and your shorts in the long run” – Dan Loeb
  • “Our short exposure is achieved by shorting individual stocks, which I think is increasingly unusual these days. But to us, it’s critical, because we want to add value on both the long side and the short side. If you use market-related indexes to create your short exposure, by definition it’s not going to add value” – Lee Ainslie
  • “A short cannot be a fundamentally long term position. In the long game, the upside is unlimited. Your downside is 100%. In shorting it is opposite. Shorting is also essentially borrowing, so you need money and time on your side. If time is not on your side, you can be right but lose all your money. The best kind of short usually has some kind of fraud. In those situations, management is determined to keep the fraud. So shorting is a short term game. When those positions go against you, there is huge leverage that can utterly crush you” – Li Lu
  • “From time to time, you will lose some money on paper. But it is just part of the game. This is why I closed long/short. You know I went through three bubbles. The Asian Financial Crisis, the Internet Bubble, and this most recent financial crisis. The biggest mistake I made is not being able to pick up undervalued companies where I had a unique insight but was tied up with this whole long/short thing. The money I left on the table is still adding up. I am still paying for those mistakes” – Li Lu
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