My Favourite Shorts
This article was published in Spanish in Trader Secrets and in English in Stockopedia in January 2013Let’s talk about the best short positions to finance your longs and reduce the volatility of your preferred long term bullish investments.
In a market where investment recommendations are predominantly positive, where stock market corrections are considered anomalies and upward moves are deemed “fundamental”, where the mantra of “do not fight the central banks” is almost religion, we forget that this bullish macro environment provides fantastic opportunities to generate alpha with shorts.
As I’m sure you will be tired of bullish recommendations, “value opportunities” and “everything is discounted” messages, today we will talk about shorts.
As a friend of mine says, in a hedge fund making money with longs is work, making money with shorts is pleasure. And regarding short positions there is a not-surprising widespread myth: it is not easy to find long term shorts because the risk is asymmetric. That is because even when one finds a Lehman or a Bankia it cannot fall by more than 100%, but stocks can rise much higher.
This is true, but we forget that the role of a short position is not exactly “to go down”, but to finance a long position and reduce volatility. And once you have found that stock you love, where you see a huge potential but also a high level of volatility and a significant risk, you can fund that position with a good short. Do not surrender to beta and close your eyes.
In Europe it is rare to find minority investors that finance their long-term good ideas with short positions, but here in the UK or the United States it is very common, and learning to mitigate volatility is part of the success of investment, whether as an individual or institution, especially in a market where moves are exaggerated, violent and very short term.
That’s why the best thing you can find in the world are those gems of shorts that tend to behave worse than their peers over the years.
Forget the ECB, the BoJ, the Fed and the Bank of England. There is a very clear reason why certain companies in selected sectors such as semi-state owned electric utilities, telecommunications, some integrated oil companies, construction and concessionaires tend to under-perform their indexes: value destruction through the investment process. Companies spend money to generate lower returns. Running to Stand Still. These are the jewel shorts, and bullish market environments create “short on strength, never buy on weakness” opportunities.
How to identify a good short for the long term.
Those who read me regularly in El Confidencial
know that I always say that, when you read an analyst report, the three sentences that will alert you to a possible short, a company of value-destroying qualities, are when you read “it’s a good company,” “fundamentals have not changed” or “dividend yield is high.”
a) “It is a good company”, is irrelevant when it comes to generating superior returns in the future, which is what you buy in a stock. Remember to distinguish between industrial companies and financial investments. A “good business” can be a great company to send them a resume and work for it, but that does not mean it will generate higher returns, shareholder value or grow margins.
b) “Fundamentals have not changed,” which usually means that the company lives off the memories of a glorious past and legacy assets but the forthcoming results will be poor for many quarters.
c) “Dividend yield is high” Careful when dividend is unsustainable and hides balance sheet risk. It is deducted entirely from the stock price. It should be noted that, on many occasions, that dividend is paid with debt or -worse- in shares, and a high yield usually hides low growth, very mature businesses and diminishing returns. Of course, there is a golden rule … when a stock exceeds a 7% estimated dividend yield as shares collapse, usually you will see afterwards a cut in shareholder remuneration.
There are cheap stocks because they deserve it. They are called “value traps”, and these are the best shorts you can find. Because they are “optically cheap” and remain so for many years.
Why? They destroy value. Use the ratio of EV / IC / ROIC / WACC, which measures how expensive a stock is relative to its investment process. If the company generates a ROIC (return on invested capital) that is lower than WACC (cost of capital) and the enterprise value (EV, market cap plus debt and financial commitments) exceeds its invested capital (IC -including provisions and “write-offs”), then the stock is more expensive even if the shares have fallen in the market.
A value trap tends to destroy shareholder value through megalomaniac “diversification” acquisitions, which analysts and management always consider “small”, or through large capital expenditure programs with very poor returns. These are companies that, through the process of making acquisitions and investing, become “fatter” not “stronger”. They become destroyers of value where the executives in charge of the different divisions or businesses are consumers of budgets, not managers to improve profitability.
Similarly, there are stocks that are expensive and deserve to be so. Companies that create true value become more expensive without the need for acquisitions or mergers, they are expensive because they are more profitable, stronger and because they focus on what they actually do well.
Value trap examples abound and tend to be concentrated on what governments call “strategic sectors” -that is, where uncontrolled spending and investing in political ventures is typical- are often semi state or privatized firms but with huge cronyism -where managers are not entrepreneurs, but VIP employees appointed by governments and where the goal of the managing team is to remain in their positions, not create shareholder value. It is common to see the top executives of these firms receive a gigantic fixed remuneration but very few own shares -or very little stock- of their own company compared to their personal fortune.
The misalignment of risk taken, exposure to the shares, and objectives between shareholders and management team is a critical factor in identifying a value trap.
These ”value traps” usually follow a vicious circle:
- The companies are “pro-cyclical”. They buy high when the market is “hot” and sell low when debt drowns them. Acquisitions are made at steep multiples for alleged “growth” markets or to “diversify”-if they have to diversify is because something is wrong with their core business.
- They always “invest” late. These are companies with multi billion capex plans but almost always targeted at copying what their leading competitors do, creating a bubble in which everyone participates, until it explodes.These are companies where investments are made by committee, with optimistic estimates where corporate advisers are afraid to deliver bad news to management teams. Where “yes-sir” internal policies reward mediocrity and cronyism …. Using the shareholders’ money in ventures where powerpoint justifies any optimistic expectation. And afterwards come the downgrades of the company’s own estimates … the profit warnings, the capital increases and convertible bonds… without costing anyone their job.
- This cycle always leads to excessive debt, because the “growth” always disappoints, and because margins deteriorate. It starts with justifications – “we can afford it” – then continues with shareholder-dilutive actions (convertible bonds, issuance of preferred stock or hybrids) and ends with write-offs, dividend cuts and capital increases at rock-bottom prices.
- Once these companies have destroyed several hundred billions of euros in value – in the Eurostoxx, 150 billion between 2007 and 2010 – … Start again.
- Back to acquisitions “to grow” and press “reset”. There will always be some CEO who will say to you that the “shares do not reflect the real value of the company”, that the “new plan is different and very realistic” and that “fundamentals have not changed.”.
At the close of this article, this segment of “strategic-semi-state owned-cronyism” stocks have underperformed their respective sectors every year for the past ten years. There must be a reason.