Updated: Sep 5
Shorting is hard ... because many assets like stocks tend to rise in value and losses are theoretically unlimited. That said, shorting can be a profitable strategy under certain conditions such as when valuations are stretched, we have a strong thesis, and we know how to manage the risks within the context of your portfolio. Most investors don't short ... and for good reason. It's complicated and the potential for losses are theoretically unlimited. At the same time, the lack of investors willing to short creates opportunities. The trick is finding the right basket of securities and patiently waiting until the right moment. We believe that moment is now for #TheBigOilShort.
This article provides the introductory road map to shorting securities. We think of it as a prerequisite to our thesis on #TheBigOilShort. The remainder of this article is structured as follows:
Shorting 101 ... facts and basics
How to structure a short strategy?
What are the characteristics of a good short?
When to enter a short position?
The Big Oil Short
1. Shorting 101 ... Facts and Basics
Before picking short positions we need to understand a bit about how they work. When we short a public stock we are borrowing shares and selling them for cash. If the stock price goes down than our short exposure will fall relative to our cash position (good). If the stock price goes up our short exposure will rise relative to your cash position (bad).
For example, say you shorted one share of Tesla in May 2019 at $50. Now your account shows an extra $50 because you just received cash for selling a security you did not own. You will also see a negative $50 in front of the $TSLA ticker in your list of securities. So what happens when the price fell to $40 and then rose to $100?
Initially, the fall to $40 translates into a negative $40 after the $TSLA ticker. This means you can buy back the share for $40, profiting $10 because you still have the $50 in cash from short selling in May. Note that the most you can earn is therefore limited to the potential scenario of Tesla going bankrupt. Even in the event of bankruptcy the price of a stock only goes to zero if bond holders refuse to negotiate and the value of debt is determined to be worth more than the company.
Downside from shorting is theoretically unlimited. Suppose the short seller in this instance decides to sell another share at $40 ... they would now have $90 in cash from the sale of both shares. By October these shares would be worth $60 each for a total of $120. That is a $30 loss compared to the $90 in cash received from selling the shares. By January 2020 these shares would be worth $100 each for a total of $200. That is a total loss of $110 ... a greater loss than the total $90 exposure initially created in May plus June.
With this example in mind there are three facts we need to know before we even think about structuring a short position...
Cost to Borrow - Verify that you are not paying interest to borrow the stock. Some shares are hard to borrow. When that happens brokers charge interest rates to borrow the stock. These interest rates are in addition to the interest from borrowing money to short the stock. Check with your broker to make sure they notify you in the event that your shorts become hard to borrow.
Dividends - When we short we have to pay the dividends. There is nothing theoretically wrong with shorting a stock with a dividend. Just remember to take that into account when putting together our short thesis. If the stock price is flat and the stock pays a 5% annual dividend we will lose 5% per year.
Tax consequences - Just like long positions, we pay taxes on gains and can offset these with losses. This provides an added incentive to employ short strategies. If we are wrong about the short strategy then we probably made money on our long exposures and can hold these while realizing our losses on shorts, reducing our tax burden. This is particularly valuable while running a long/short strategy on leverage in a separate trading account from the long only portion of a portfolio.
Leverage Expense - We hold cash to avoid paying our broker interest. If our shorts move against us then our cash position will fall below our short exposure (remember that's bad). What's even worse is the interest that brokers charge us because we are effectively now borrowing their money to short the stock. To avoid this we check the position daily and verify that our cash exceeds the short exposure. This means bringing in cash from our bank or selling some stock if our short position moves against us. We never pay our brokers interest for leverage because it is a guaranteed loss and totally unnecessary level of leverage.
With these facts in mind we can now turn to How we structure our short strategies.
2. How to structure a short strategy?
Structuring a short strategy is all about risk management. We can be right about our short thesis, but fail easily without a sound structure. We use several tools to manage risk when we employ short strategies including Strategy Loss Limits, Diversification, and Individual Security Rules.
To avoid losing lots of money and paying lots of interest to our broker we generally do five things:
1) Strategy Loss Limits ... Not Stop Loss - Decide how much you are willing to lose. When you buy a stock the most you can lose is the amount you invested in the stock. Not so for shorts. The price of a stock can theoretically rise forever so you need to set a price limit for covering your short position. That means...at some point you should cut your losses and reconsider your thesis.
Strategy Loss limits (SLL) are different than a Stop Loss Order. First, a SLL applies to a basket of securities in a strategy not an individual security. They are also executed in layers over a longer frequency. These two differences are analogous to the two questions we need to answer before we can properly set and execute an SLL...
How to set a SLL? - Stop loss orders on individual securities tend to be poor risk management tools because the volatility of a single security can trigger these stop losses even if your strategy is fundamentally sound. For example, suppose you are shorting oil exploration companies (like we are) because you believe that oil demand globally has already peaked (which we do). Suppose further that as a group these companies (in ticker $XOP) fall by 30% over the next year as this recognition becomes priced into markets. The way down could easily experience a 30% rise in individual stock prices before that fall is realized because of events like say turmoil in an oil producing country or an earning beat for reasons unrelated to oil demand. To set the correct loss limit one needs to think through how far a strategy can move against you without the strategy being fundamentally wrong. That's a tough question.
How to execute a SLL? - SLLs are best executed in layers and over a lower frequency. For example, we might decide that if our short on $XOP moves against us by 5% we would close 50% of the position...but we would only do so if the position closed down 5% at the weekly market close. This help us to avoid a scenario in which the position crosses our limit, but only briefly during the week. This also opens us up to the risk that by the time we close the position we down even more than 5% because we waited. That is why it is helpful to have layers...so we don't rely on a single SLL to cover a short position.
Setting and managing SLLs is challenging and time consuming. That is another reason shorting is hard. It takes time and we need to watch these limits in order to execute them properly or we risk potential loses beyond our initial exposure.
2) Diversification ... strategies that reflect complexity - Perhaps the easiest way to tell if an investor is ignorant is if they lack diversification. Human systems are infinitely complex. Lack of diversification is therefore a lack of acceptance that one's own mind cannot comprehend reality. We generally diversify our short positions because our short strategies tend to be risk management tools. That is different than some other managers that may specialize in short selling. We tend to view shorting as a way to reduce overall portfolio risk.
For example, we were shorting oil companies, ICE manufacturers and corporate bonds heading into the 2020 pandemic. We did not know with certainty that the essentially all financial markets would collapse harder than any crash on record. But we did have reason to believe that they might given what was happening in China. We also felt that the upside for our short positions was limited for reasons we explained in our 2020 Review and Why We Bought Tesla videos.
We used a range of instruments as well with around 15 different securities both stocks and ETFs as well as put options alongside direct shorts. The put options on corporate bonds ended up providing around half the return generated from all our shorts because the crash was so volatile. We could not have known that going into the crisis...no one could have.
3) Individual Security Rules ... Avoiding catastrophic losses - The easiest way to lose your life savings on a short is to short a stock that rocket moons. Tiny stocks, stocks with high short interest, and stocks with the potential for extremely good outcomes...these are all terrible shorts even if they are part of a basket of securities.
This is more widely understood now post the Gamestop debacle, but it has always been the case. That's not a bad game to play...because its #positiveskew. We played to, but it was not a material part of our portfolio.
We tend to avoid shorting a company that has a market cap of under $10 Billion. This is not a hard and fast rule, and by itself does not satisfy our individual security rules. What this does do is avoid a particular kind of risk...which is lack of liquidity. larger companies tend to be more liquid and this helps us avoid borrowing costs on shorted securities and being forced to cross a wide bid-ask spread when buying back shares if we cross a strategy loss limit.
We also avoid securities that we deep to have positive skew. This is not easy. But most companies are boring with small margins producing products and services that are largely indistinguishable from their competitors. #TheBigOilShort is a great example...because by its nature oil companies are easy to price because they are producing a true commodity. That makes for fairly low risk that these companies will experience some 20X increase in two years like Tesla did. Same is true for ICE manufacturers. Same is true for corporate bonds.
Risk management is key when it comes to investing generally...and that is especially true for shorting. We shared some guidelines above for how we do this. But even with a theoretically perfect risk management strategy we will still lose money if we are fundamentally wrong.
So what are the characteristics of a good short?
3. What are the characteristics of a good short?
Good shorts have negative skew. That means the security might go way down, but is unlikely to go way up. This makes the payoff of a good short akin to buying a put option. Perhaps we lose a little money for a while, but if our short thesis is correct then one day the security will miss suffer because of its sensitivity to the economy or a stock tanking after a missed earnings target.
Some securities are naturally negative skew. Bonds are in this category. But most securities outside of bonds are by construction positive skew because prices of most things can theoretically go up higher than they can go down.
Stocks generally go up over time ... or at least that has been the experience for the Russell 3000 since 1983. The study referenced below ended in 2006, but we confirmed with data going up through 2019 and also extended it to the S&P 500. Specifically, about 60% of stocks have generally gone up in a basket of US stocks over their lifetimes. However, Most are not able to outperform treasury bills.
Picking winners is really hard. This study of public stocks in the USA since 1926 shows that just 10 companies accounted for a 1/6th of total stock market returns. We had better hope we have at least one of those amazing companies in our portfolio (far right) or we are going to have a really hard time beating the market. Frankly, it's easier to hold the S&P 500 and look instead short companies that are likely to fail (far left). The reason is that a lot of the returns of an index are driven by a small percent of the companies in said index.
Some securities are naturally structured to be negative skew. For example, we were shorting a 3X leveraged long ETF on Oil & Gas exploration companies heading into the pandemic. A big reason why is that these leveraged long securities tend to perform even worse than the underlying over long periods of time. They are designed in a way that exposes them to catastrophic risk for reasons we explain in the video (Click picture).
Shorting bonds and leveraged ETFs is easier because they are negative skew by structure...but what about stocks? How does one identify a company with negative skew?
The easy answer is look for the opposite of a good company.
Negative Skew Stock Traits
Ripe for disruption
1) High Competition - Most firms lack moats. Restaurants, clothing stores, convenience stores, car rental companies...etc are all highly competitive businesses with low barriers to entry. You only want to short businesses that have no possibility of sustained above average profitability...and that’s not so hard to find. Companies with positive skew are far more scarce.
A special case of negative skew firms include those subject to perfect competition. These include commodity producers such as oil extractors and refiners, transportation services like trucking, car rental, hotels, and farming. When the product you produce is the same as your competitors then you have very little hope of sustained profitability.
2) Downward trend - Many firms in highly competitive industries are still able to be profitable for long stretches of time. For example, the hotel chain Marriott has done well since going public in 1993 so long as the economy was strong. That’s why it’s important to wait for a downtrend. No one can hope to understand all the complexity of even a simple business model like a hotel chain...but headwinds that cause a firm to miss earnings projections often have long life cycles. Marriott has been struggling the past 1.5 years as AirBnB took market share. AirBnB isn’t going away. Hotels are simply more competitive than they used to be. Wait for an earnings miss and a sustained downward trend in price before going short.
3) Bad product/service - Don’t ever short anything that creates someone its customers uniquely value. It’s just that simple. If it brings them joy or solves a unique problem then the company is not producing a commodity. Traditional auto dealerships are a great example. Buying a car is painful process of haggling over price, losing 30% of its value the moment you buy, paying insurance, finding a good parking spot, taxes on new cars, car mechanics taking advantage of information asymmetry, trading in your used car for 70% of what you could get, trying to sell a car yourself ... Every aspect of the car ownership lifecycle: buying, owning, and selling a car is a painful experience that we go through because we have to...or did until now.
4) Ripe for disruption - Painful experiences like the lifecycle of car ownership are ripe for disruption because they account for a huge part of the typical household budget and are just now starting to become an option instead of a necessity. Algorithms that price stocks based on historical revenue growth and margins have no clue what’s about to happen. They just extrapolate prices right off the cliff. By targeting industries that are just becoming disrupted you can take advantage of the models that are used to price public securities.
The challenge here is not so much listing these traits, but applying them in practice. Then there is the final step of timing the entry and exit.
4. When to enter a short position?
Work-in-progress ... stay tuned for next week.
5. The Big Oil Short
The Big Short tells the story of investors that took huge bets against the US housing market. Their story is fascinating in part because very few people recognized the housing bubble and even fewer had the courage to bet on a never before seen national collapse in home prices. We think the same thing is happening now to the oil market and related industries including internal combustion engines (ICE), and current transportation industry at large. Many have heard of autonomous driving, electric vehicles, and mobility-as-a-service (MAAS), but few appreciate the speed, size and scope of their disruption.
For more than a century, transportation in the United States and across the industrialized world has been dependent on manually operated internal combustion engine (ICE) cars and trucks. But disruptive technologies like electric vehicles (EVs), mobility platforms like Uber Lyft & Turo, autonomous self-driving technology, demographic trends like aging and urbanization, and cultural trends like environmentalism and the services economy are threatening entrenched industries including oil companies, ICE manufacturers, car and truck dealerships, gas stations, auto mechanics, railroads, car insurance companies, and brick & mortar car rental companies.
We are publishing an application of our "How to Short" philosophy next week for subscribers interested in understanding our new short positions (Link) subject to heavy revisions. Click the picture above for details.
TheBigOilShort is the first of a three part series on our short strategy. Oil is only one component...and we expect the total impact of the revolution in transportation to come in waves. We expect losers to suffer in the following order and will publish parts 2 & 3 as we near their respective inflection points...
Part 1: The Big Oil Short
Part 2: The Transportation Revolution
Part 3: Autonomous Driving
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