Single-Stock Shorts: A Focus on Aggressive Accounting
Single stock shorts and our pivot to focus on 'aggressive accounting'
This Insight is not investment advice and should not be construed as such. Past performance is not predictive of future results. Fund(s) managed by Seraya Investment may be long or short securities mentioned in this Insight. Any resemblance of people or companies mentioned in this Insight to real entities is purely coincidental. Our full Disclaimer can be found here.
This Insight is an extract adapted from the Panah Fund letter to investors for Q4 2015.1
If we were to identify one area where we have been unhappy with the fund’s process and performance over the last two years, then it would be our track record of generating single-stock short ideas.2 Our long stock positions and macro hedging have made solid contributions to the fund’s performance since inception, but our single stock shorts have added little to performance in an environment when they really should have done so. We have not done a large amount of shorting so far during the fund’s life, but it would be true to say that for every single stock short which has made us money, another has hurt us.
Shorting stocks is one of the hardest investment skills to exercise consistently. It is also probably fair to say that it usually requires much more time to develop a thorough fundamental short stock thesis compared to a long. It also requires plenty of conviction, as a short position is liable to go in the wrong direction first, which hurts more as the position size increases. The temptation to cover and ‘stop the pain’ can be huge. Nevertheless, we think it is well worthwhile to get shorting right, as it can provide a valuable source of alpha.
A good fundamental investment process should also be able to identify ‘problem companies’. This provides two benefits: not only should it help us to avoid these stocks in the long book, but some of these stocks also become candidates to short.
In life before Panah, I had a reasonable degree of success in short-selling. I have thus been giving some thought as to what is different now.
First, for the first 24 months of the fund’s life, most of our investment time was spent developing a core book of long stock positions for the portfolio and getting the macro calls right (particularly on the currency side, where hedging has been important). In retrospect, we probably did not devote the necessary time to finding the right fundamental single stock shorts. This has started to change recently, however, as our resources have increased.
Second, on reflection we think that the style of shorting we have been using over the last two years has not been the most conducive to recent market conditions. In our view,3 there are probably four different types of stock shorts:
Earnings disappointments, where stocks fall temporarily because of a shortfall in earnings relative to expectations;
Valuation shorts, where prices have run up to levels which are unwarranted by fundamentals, and suggest a 'bubble', making them vulnerable to any negative catalyst;
Macro/sector shorts, where the external environment overwhelms the company (for either structural or cyclical reasons); and,
Aggressive accounting and frauds, which, in a best-case scenario typically leads to downward mean-reversion for earnings (and share prices which have been aggressively managed up), and in the worst-case scenario ends with bankruptcy and jail time for executives.
Of course, a combination the above is also welcome to short sellers, for example a stock with a high valuation with an earnings disappointment as a catalyst; or perhaps a company with aggressive accounting and a high valuation. In many cases, it is painful and uneconomical to short a stock – no matter how flawed the company – without also identifying an imminent catalyst which should lead to a fall in the stock price.
To date, the Panah Fund has mostly sought out macro/sector structural + cyclical shorts, as well as valuation shorts, usually with a downside catalyst such as an earnings miss.
Our macro/sector shorts have worked out fairly well so far. Examples include: a major Korean smartphone maker as its smartphone revenues started to come under structural pressure from cheaper Chinese smartphones; and a Japanese construction machinery maker as excavator demand collapsed on the back of China's cyclical (or structural) slowdown.
Our high valuation + catalyst stock shorts, however, have seen limited success. Several of the expensive stocks we have shorted have not reacted much at all to earnings disappointments, or else have bounced back quickly and become even more expensive.4 This market behaviour also seems reflective of a macro environment where interest rates have been close to zero in many parts of the world, as investors have clustered into 'theme’, ‘growth’ and ‘momentum’ stocks (especially in tech, consumer 'brands', healthcare, etc.). It might well be that this will change now the Fed has started to raise interest rates, but we are not betting on this outcome.
Instead, over the last six months we have been working hard to add another string to our bow, namely a way to seek out companies which employ aggressive accounting techniques.
Aristotle wrote, “Men are good in but one way, but bad in many”.5 Leo Tolstoy echoed these sentiments in ‘Anna Karenina’, “All happy families are alike; but each unhappy family is unhappy in its own way.” Misappropriating these words of wisdom for our own ends, we find that good companies are fairly alike – in that they must be free of (almost) all deficiencies – but bad companies can go wrong in any number of different ways.
When searching for these bad apples, we must thus cast our slide-rule over a large number of potential problem areas. Over the last six months we have developed a comprehensive quantitative 'red flags' screening system which identifies potential financial manipulators. We take accounting data for all companies within our investment universe (currently ~13,000 companies) and rank 80 different metrics against peers within each sub-industry group and against their own histories.
The metrics fall into six main categories:
Income statement;
Accruals;
Assets, investments, & intangibles;
Debt;
Related party transactions; and,
Composite measures.
Where there are a large proportion of abnormal metrics (or 'red flags'), this indicates a higher likelihood that we have found a 'problem company'. The quantitative techniques we use are based on academic forensic accounting research, fundamental analysis, and our own examination of recent Asian fraud cases. It is encouraging to note that a fair number of the companies which have ranked near the top of our ‘red flags’ list in previous years, have since been accused of fraud or had to restate their numbers.
It has taken significant time and effort to develop the ‘red flags’ framework, and this work has only just come to fruition. The firms which currently have the highest ‘red flags’ scores are providing us with some highly prospective short candidates which we think have a reasonable chance of being involved in accounting manipulation. We have already started to investigate some of these firms in more detail and are hopeful that our 'red flags' system will help build a foundation for more successful stock shorting in the future.
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
Shorting involves borrowing stock and selling it in the markets with the intention of buying it back at a lower price in the future; if the stock price falls, the fund profits.
This is inspired by analysis in ‘The Art of Short Selling’ (1996), Kathryn Staley's classic book on shorting stocks.
There is probably a lesson to be learned here about the need for agility (i.e., using stop losses better, and/or looking to take profits and cover positions on a sell-off rather than holding on for more downside).
