Several skills important for shorting stocks say hedge funds

Source: Hedge Funds Review | 08 Aug 2013

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Wide range of skills needed to short successfully

Shorting requires a trader to balance conviction in an idea and the desire to see it through to a profitable outcome with real risk management discipline

Matt Taylor, Kortright Capital Partners
We approach our long and short investments with the same set of criteria and the same investment process. We focus on small and mid-cap stocks at interesting and complex points in their corporate lives. Specifically, we look for companies in industries where we can do deep fundamental work but where some element of complexity related to either the balance sheet or corporate activity is causing market participants to look the other way.

Many event strategies do not lend themselves to short-selling because most corporate activity is at least designed to create shareholder value. However, the best corporate intentions do not always yield positive results.

We focus on several key questions when making short investments: is value being created or destroyed over a reasonable timeframe; is the market appropriately discounting either scenario; are the underlying fundamentals of the business a challenge relative to the company's valuation; and is the rest of the capital structure a potential problem for the value of the common equity?

Getting the answers requires an ability to analyse corporate event activity, levered balance sheets and business fundamentals. These are also the skills most relevant to our long investments.

However, making short investments requires an added dimension of risk management. Stocks can theoretically go up forever but can only go down to zero. That makes the risk/reward ratio of short investments negatively asymmetric relative to long investments.

The result is that shorting requires an additional skill: balancing one's conviction in an idea and the desire to see it through to a profitable outcome with real risk management discipline.

Anis Lahlou-Abid, portfolio manager of JP Morgan Europe Dynamic Long/Short fund
Shorting can be risky because of the inherent asymmetry in the trade: stocks go up more often than down and have unlimited upside, meaning potentially unlimited losses for the short trade. Takeover premiums and short squeezes are reminders of that.

Such was the case with Volkswagen in late 2008, when its stock went up five times (from €200 to €1,000) in less than two days making it briefly the world's largest company by market cap. Many investors with short positions lost a lot of money.

Yet, analysing our 10-year history of shorting in the JPM Europe Dynamic L/S fund, the reality appears different to conventional thinking. Provided a certain number of rules are strictly followed, shorts are not only a significant source of performance, they also reduce the volatility of returns as they are negatively correlated to longs.

The overriding rule is to avoid behavioural biases and rigorously follow trends and earnings. For example, after a decade of raising and beating expectations, Apple's first earnings downgrades signalled a change in trend while the stock was still a consensus long trading near $700.

Then, once a trend is established, ride your shorts until the trend reverses and remember to reload shorts as they are working, rather than closing them as the position becomes smaller.

Perhaps the most important rule is to diversify your shorts and avoid bid stocks: shorting is about having the right sizes across multiple names, not just one concentrated short. One or two profit warnings should more than offset 10 small squeezes and sideway moves.

Richard Travia, Tradex
Few investors are truly comfortable being short. That goes for individuals as well as institutions. As investors we simply are not wired to approach short selling with such ease.

But as allocators in a performance-driven world, being a talented and aggressive short-seller is a necessary trait that is very much part of our DNA - akin to survival skills in the ‘kill or be killed' investment jungle.

Tradex has historically made some of its best returns being short various assets classes, such as subprime mortgages, high yield corporate debt and equities, to name a few. A certain amount of aggressiveness was needed to pull off these trades.

We feel aggressive, contrarian thinking should be an important part of every investment process and thesis and its development should help to build and support the short or long side of any trade.

Without understanding the bull and bear cases, one might find yourself being fed to the wolves.

While timing is always important - and gut feel plays a large role in that - a thoroughly researched investment case where true asymmetry exists can help offset the need for perfect timing for investors that have lost their crystal ball.

Our favourite types of short trades have mathematical asymmetry on their side. Mathematical asymmetry is about more than having a strong opinion - it means there are factual and mathematical limits to the losses and the probability of a gain is skewed positively.

We currently see shorting high yield corporate bonds as a mathematically asymmetric opportunity that needs to be pounced on.

Topics: Hedge funds, JP Morgan, Short, Top story

Friday, August 16, 2013