The Art of Short Selling - Wealth With Risk

Short sellers unearth facts from financial statements and from observation to ascertain that a stock is overpriced. Short sellers are information-based traders. Before 1983, no solely short funds existed. Stocks can only go to zero on the way down, but can go to infinity on the way up (reply: I've seen a lot more stocks go to zero than to infinity). Short sellers take greater risk than other investors - they must have strong evidence to support cases for price declines. Becauses reverses are sudden and terrifying, the burden of evidence rests on a solid, careful analysis completed before the stock is shorted.

Short selling is a niche. It is very small relative to the stock market as a whole. The long bias of and in the market creates exploitable inefficiencies for shorters, ie. there are more overpriced stocks than underpriced stocks (Asquith and Meulbroek). Negative earnings surprises affect stock prices to a greater degree than positive earnings surprises, and that effect persists over time. The common wisdom that there is no such thing as one bad quarter has a statistical basis. Stocks become torpedo candidates when very high expectations give way to earnings disappointments.

Short sale candidates cluster in three broad categories:

1. Companies in which management lies to investors and obscures events that affect earnings.
2. Companies that have tremendously inflated stock prices - speculative bubble.
3. Companies that will be affected in a significant way by changing external events. 

The trail signs to look for:

1. Accounting gimmickry: clues that the financial statements 
2. Insider sleaze: inurement, insider sellling.
3. Fad or bubble stock pricing: large price rise over short period.
4. A gluttonous corporate appetite for cash.
5. Overvalued assets or an ugly balance sheet.

The main precept of short selling analysis is bulk. Volumes of disparate facts and observations.

Accounting-based analysis is not difficult to do, but it takes time, patience and a suspension of belief.

The lack of attention by other professional investors to financial details provides the inefficiency in information dissemination that is so central to the short sellers art.

The goal is to identify the tragic flaw in a business long before the company's demise (the death rattle of a company in decline). The art of short selling trains analysts to avoid torpedo stocks or to profit from them.

The main weakness of short sellers is the inability/difficulty in judging the timing of collapse. Short sellers are consistently years too early when they sell stocks. Short sellers fear most a sustained rally in a stock.

How to make money in short selling and how not to lose money by selling are different sides of the same coin.

Short selling is a game of wits with the odds in favor of the analysts who do hard work and think for themselves, who turn jaundiced eyes on what passes for Wall St wisdom.

The Art of Short Selling - Preface

The analytical methods of great short sellers are characterized by prodigious analysis attentive to (1) the quality of earnings, (2) quality of assets, (3) and, quality of management.

You are looking for a bad business run by incompetent managers.

The years 1991 to 1993 decimated the population of short sellers. Those years saw the ascendancy of mutual funds, of momentum investing, and of the short squeeze.
(sounds eerily like 2012-2014 with ETFs, momentum investing, and short squeezes)

The simplest techniques work year in and year out - rising inventories, and insider selling.

Bernard Baruch on Bears

Bears can make money only if the bulls push up stocks to where they are overpriced and unsound.

Bulls always have been more popular than bears in this country because optimism is so strong a part of our heritage. Still, over-optimism is capably of doing more damage than pessimism since caution tends to be thrown aside.

To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without a free press. There would be no one to criticize and restrain the false optimism that always leads to disaster.

Quote at the beginning of "The Art of Short Selling."

Short term gain for long term pain

Mr. Putin appears to have come out on top with the West in his annexation of Crimea.

I don't think so.

Russia is heading for recession. Pent-up social discontent is likely to manifest when the good times pass. He has garnered tremendous short term gain at the expense of long term relationships.

Irrespective of whether Putin is around, this one will come back to bite Russia. 

Perhaps the most important ingredient to being/becoming a good investor...

...patience.

When I look back over the myriad names that I have owned and the reasons I owned them, and then look at when and why I sold them, and look at them now. I would have in virtually 90% of the cases have been much better off holding them than selling them.

The key ingredient that was missing from my investing DNA was patience.

Patience allows the compounding effect of time, the market (generally upward skewed) and your thesis to play out.

It's a set-up

Not an intentional set-up. Not a malelovent set-up. But a set-up all the same.

The set-up is this. The market is extended. But we already knew that. We have been conditioned to buy the dip (Bernanke put and everything). Everyone is happy. Stocks have gone up. There are no signs of disaster around. The economy is healing. However, there are signs of momentum sapping and sentiment changing. The coup de gras is a combination of respected commentators talking caution (Marks, Montier, Dalio, Gundlach), Fed tapering, meme that new Fed governor will be tested, geopolitical conflict & China cracking.

This is how the worm turns. And this is how it takes time for the market to digest the turn and then in turn justify the takedown. All of these things and more have been around a long time. Fear and risk are always there. But there are times when the market sits up and takes notice. I think now is one of those times. I am trying to lighten up going into mid-14, but it is hard to sell names that I think are good long term plays (even when I know they WILL take a 20%+ haircut in any takedown).

China! China! China!

How long, oh China, will you defer reality?

How long, oh China, will you defy gravity?

How long, oh China, will you run roughshod over the laws of economics?

How long, oh China, will you continue to mock us who doubt?

How long?





Maybe not all that much longer.
http://www.macrobusiness.com.au/2014/03/morgan-stanley-chinas-minksy-moment-is-here/

Why and how the market can keep going up as breadth disintegrates

The S&P 500 is at 1878. It is up 1.61% YTD, 23.7% 1 yr, 31% since January 2013, 62.5% since October 2011.

The Nasdaq Composite is at 4,336. It is up 3.2% YTD, 36.8% 1 yr, 42% since January 2013, 75% since October 2011.

Those are all big numbers. Especially in the context of an anemic economy and being toward the end of a regular market cycle.

Earnings growth has been substantial. The S&P is trading at 15x forward earnings. The Nasdaq is trading at 18x forward earnings. Valuation is above average but by no means extreme or even stretched. It could also be argued that with rates low and expected to be low for a long time, multiples could be substantially higher. The march higher has been broad based, lead by small and mid caps.

Beyond the aggregate data, I think there is another catalyst that I have not seen talked about that could easily see the major benchmarks substantially higher (even as the broader market and market breadth falls away).

That catalyst is the low relative valuation of the benchmarks major components. The top 10 companies in the S&P 500 comprise 18% of the benchmark weighting. The top 10 companies of the Nasdaq Composite comprise 32% of the benchmarket weighting. Those companies look to me to be substantially undervalued relative to the benchmarks smaller components. If their multiple were to rise from an undervalued average of 13x to a more normal 15x, then that could easily propel the indexes much higher (throw in earnings growth and dividend yield for added support), even as breadth trails off.

A "bubble" in growth

The market has experienced a massive run over the past year and a half. Much of that is due to the economic/political clouds clearing, confidence repairing, earnings coming through and ZIRP (and all its manifestations, eg. Bernanke Put, etc.) supporting a one-way trade.

But there is no doubt in my mind we are experiencing a growth bubble not too dissimilar to the internet bubble (which granted was a great deal more diffuse) in a number of places. These companies are characterized by rapid revenue growth, low to no profit, and the prospect/hope of future leveraged profitability - sound familiar. What is scary to me is that like the internet bubble it kept going and going until finally you threw in the towel and drank the kool-aid yourself. There are no signs of multiple expansion declining. No signs of a prick.

We will wake-up one day, two weeks, three weeks, four weeks past the peak and realize the game is up. For me that will mean watching the aftermath. I am hopeless at chasing. I will likely have been burned badly fighting it on the way up only to have capitulated and failed to have a position (or worse had a position but failed to have the conviction/patience to let the position ride) to capitalize on the bursting.

There will no doubt come a time when the market will once again focus on long term sustainable profitability with a degree of scepticism toward these sectors (which will likely result in overshoot on the downside). The scales will fall and the reckoning will begin.

Main areas where a bubble burst in valuation will be felt: SaaS, big data, analytics, cloud, biotech, social media.