Thread by @FundamentEdge

THE SHORT SIDE

Oh, short-selling. The bliss. The horror. I don't think anything in this business feels better than nailing a short.

The analytical work required, the independent thinking to go against the prevailing narrative, the guts to stick with a scary position - when

it works, it is just the best feeling in the world. It's a powerful drug!

But holy crap if short selling isn't hard. And I've got lots of battle wounds, believe me.

The first one that comes to mind is TDOC. This stock at $200 hit a lot of the hallmarks of a great short.

1) temporary tailwind that was set to dissipate, 2) further along in TAM saturation curve than market conceptualized, 3) aggressive competitive incursion, 4) absurd valuation, 5) catalyst in imminent decelerating business momentum.

Great short, right? Well, I shorted it, and it

almost immediately went up 50% in my face. Cathie Wood was espousing some totally absurd virtual primary care thesis. And what was a 4% short became a 6% short, or would have. Running market neutral, a 2% hickey on one idea is NO BUENO, so as the stock started ripping in my face

I was forced to cover, locking in losses. So I'm covering, covering, covering to stay in the game, then something insidious happens. I start to question myself. Is my thesis right? So I size it down a bit. Our reptilian pain/pleasure driven brains don't like pain, we want it to

stop instinctively. We are wired to avoid pain, evolutionarily. So with what was a 4% short and moved up to a 5% short, that put a 1% hole in my P&L, I convinced myself maybe I should be a bit smaller, and took it down to 3%, locking in even more losses.

Then it starts to crack. RELIEF!! The incessant pain is over, and it feels so good. And you see a stock down big, and my first instinct (as NOT a wizard, as a mediocre PM) is to cash some of those gains. "This has been such a problem stock, now I'm making money on it, I want to

lock this in" was my thinking. So I take the 3% position down to 1.5%, getting some of my losses back. I keep that as a small position, and it feels nice as it continues to unravel, but it goes to $150 and I cover to have room to re-short a bounce. And it never bounces. Crap.

What was almost a perfectly constructed short thesis, with timing that was only off by TWO MONTHS, ends up actually being a net money loser for me. (I needed a Wendy Rhodes to yell at me to put my foot on the stock's neck as it died a painful death...)

WELCOME TO SHORT SELLING!!

SHORT SELLING IS HARD

Short selling is just incredibly hard. That's the fact. I have so much respect for PMs who manage short books well, and funds who generate consistent short alpha deserve their fees.

There are structural reasons why shorting is hard.

1) UNLIMITED RISK. A 5% long position if it goes to zero costs you 5%. And as it declines, it naturally becomes a smaller position. It's easer to let the shares owned ride, or even double down. NOT TRUE of a short. If you have a 5% short, and it doubles, it could double again!

Then all of a sudden a 5% short has cost you 15% to gross. This is a bigger problem than it seems, because hedge funds are reliant on LEVERAGE to turn lower returns on gross into higher returns on equity.

A 15% hit on gross for a 400% gross market neutral fund, for example,

would be a 60% hit to equity!!!

Ask most people who know of him, and we would tell you Gabe Plotkin is one of the best investors of our generation. But when even a small short like GME goes from $4 to $40, against a levered fund structure, it's an incredibly hard situation.

2) EVERYONE IS WORKING AGAINST YOU. The S&P 500 has gone up roughly 10% a year for the last 30 years since S&P 500 revenues are levered to nominal GDP. Nominal GDP growth drives revenue growth, operating leverage drives profit growth, and cash deployment drives dividends &

buybacks, propelling EPS growth forward. This dynamic is why stocks tend to rise over time (when economies stall, as Japan, this works in reverse). The majority of companies, particularly large companies, are growing, so with business growth, time is not on your side. And timing

is very hard to get right (see TDOC example).

The entire ecosystem is incentivized to have stocks go higher. CEO's are measured by stock prices, so they buyback stock and try to create value (or an activist will do it for them). If they fail, they might be forced to sell

to an acquirer. Some insane % of sell-side ratings are buy ratings. Jim Cramer is out there pounding the table. The Fed (with current exception) is inflating assets. So being a short seller is a lonely operation, and you are working contrary to the system. Get used to it!

3) IT IS VERY COMPETITIVE. In 1997, ~30k people sat for the CFA and there was $120bn hedge fund AUM. Today, ~270k sat for CFA in 2019 and there is $4.5trn hedge fund AUM. And these CFAs & hedge funds are all hunting for shorts.

And the pool of shorts isn't growing, it's probably

shrinking (through the dreck that came to market last 3 years helped). As total number of public equities decreases, winner take all dynamics lead to scaled players in industries, it's harder to find great ideas. And as funds scale in AUM, they have to start shorting more liquid

stocks. If a fund needs $30m ADV for a short, that's a PRETTY small universe of US stocks to short. So many hedge funds end up shorting the same stuff, driving short interest & days to cover higher, driving violent de-grossing periods a handful of times per year, and sometimes

limiting how bad the downside gets (every short becomes a buyer at some point). And if you are wrong on a crowded short, IT HURTS.

Borrow fees also make it hard. SHLD was one of the most compelling short ideas I have seen, but everyone else saw it too, and the demand for

borrow led to really high borrow rates. If a death happens slowly (as it did with SHLD), those borrow fees can eat up the bulk of your short P&L.

THE DIRTY SECRET

So shorting is hard. The dirty secret is that the bulk of P&L in the hedge fund industry is generated on the long

side. And a fed induced bubble over the last 14 years post GFC has even further reinforced that dynamic. When reply-guys tell me HF's suck, I think in my head "well, some HF's have become levered long vehicles shorting the index or bond-proxy stocks, and that worked for a while,

but isn't now". I can't predict the future, but I generally have a view that the best performing HFs over the next 5 years will be those that can actually generate real alpha on the short side. It's brutally hard, but some will figure it out.

I forget the article, but I read that Jim Chanos made much more money with his S&P long hedge than his short book over time (if someone has it, please post it in replies!). That shows you the reality of shorting.

TO BE CONTINUED

Another funny instance...when I was launching a fund I went to Whitney Tilson's How to Launch A Fund Seminar, and he talked for a couple hours about how he wish he never shorted a stock! (this was a guy who was on 60 minutes talking down Lumber Liquidators). Shorting is HARD.

LONG-SHORT SPREAD GENERAITON

Why is shorting so important to a hedge fund? Let's talk about some structural basics. A market neutral fund has a beta of zero, so market goes up, market goes down *theoretically* there should be no market exposure, as gains on shorts perfectly

offset losses on longs.

And if executed well with real long-short spread generation, a market neutral fund can generate P&L without any beta exposure.

In this example, if a fund's longs are up 10% and shorts are only up 5% (+5% LS spread), at 400% gross exposure, 2.5% return

on gross translates into 10% return on equity. And these 10% returns are not created equal.

Given that the market neutral fund is taking zero beta and likely minimal factor risk, aggregate volatility is lower, and thus, sharp ratio is higher (want to get an LP excited? Tell

them you have a 2-sharpe strategy).

So for some funds, can you just give up on shorting? Short the index and some lazy placeholder shorts? Yes. Some have. And in a bull market, that has worked. But will the next 5 years be the same sort of bull market? If you don't think so, it

might be a good idea to learn how to short stocks!!

IS A SHORT JUST AN OPPOSITE OF A LONG?

Yes, and no. A FEV (fundamentals, expectations, valuation) framework on a long says to look for a company with good & accelerating fundamentals,

https://twitter.com/FundamentEdge/status/1554829073636999169

low expectations and cheap valuation.

That can be inverted on a short. A good short, to me, has weak and/or decelerating fundamentals, high expectations & expensive valuation. It's the interplay that matters.

But in other ways, shorting is not simply the inverse of a long.

A catalyst matters much more, as getting the timing right is critical.

SHOOT TO KILL OR SOGGY SHORT?

I generally view the revenue/EPS algorithm as a good baseline starting point as the cost of my short. If I'm short a 20x P/E stock growing EPS by 5% per year, if the P/E holds,

I've only lost 5% in 12 months (rolling P/E multiple forward one year). That would be a soggy, slow growing short.

But I put on my "shoot to kill" shorting hat, I'm basically saying if I don't get the timing right on a stock, it could hurt me. TDOC was a shoot to kill short.

I worked with an analyst who absolutely LOVED shoot to kill shorts. Frauds, failures, all of it. He hunted for shorts that could go down 30-60%. And sometimes he found them. But sometimes, they would squeeze in his face 50-100%. I've shorted a steady dose of shoot to kill shorts,

but the reason I've had modest success as a short seller over my career has been soggy shorts. Finding businesses stuck in the mud, swimming upstream, with a steady secular headwind. For me in healthcare, names like OMI, PDCO, WBA, CVS, JNJ, CERN and TEVA have been, at various

points, gifts that kept on giving. Layering in a steady dose of "soggy shorts", i.e. businesses that have key drivers that struggle to show profit growth, can provide a healthy baseline for my short book that hedge my compounding longs - in healthcare, HCA, UNH, HUM, ISRG, TMO,

DHR, BSX, SYK, ALGN (at times), DXCM (at times), ISRG (at times) and I'm setting up a nice baseline alpha spread where I'm owning better, high quality growing businesses on the long side against weaker, slower growing businesses on the short side. This is a stylistic

preference, obviously, but then I will pepper in more opportunistic "shoot to kill" shorts into that short book, and generally keep them small and size them up into catalysts (usually prints).

So on the hedge fund size, the lens that I always used was more spread generation.

Find a group of longs that can sustainably outperform a group of shorts as the foundation for your spread generation (risk is this just creates a consensus book, however).

CYCLICALITY OF SHORT ALPHA

I need to find some data on this, but one thing I've

experienced in my career as a short seller is the cyclicality of short alpha. A good long can be an up and to the right grinder. Very few shorts are a down and to the right grinder. Squeezes, dumps, violent moves - that's the name of the game in shorting. And it always felt to me

like 6 months of pain for 6 days of fun (and when the short book works, it is FUN), at least in concentrated short books. So just know that. Concentrated short sellers are not designed to make money every month.

SHORTING & M&A

One of the most obvious shorts I've ever seen in my career was Martek, an omega-3 ingredient company that was losing its patents. I was convinced the biz was just set to unravel. Then, DSM bought them for a 34% premium.

I was similarly convicted about MDAS, a GPO

that was set to have competitive issues. Enter Private Equity takeout.

Catamaran, a PBM having competitive issues. UNH buys them.

And the one that is most vivid in my mind, BIVV. A lazy hedge short in my book that went up 64% after being acquired by Sanofi.

Why do I tell you this? I think I've caught 2 take-outs in my long book over 13 years of investing, and maybe taken 10 shorts to the face on M&A?

WHY? I've come to a belief that the information asymmetry associated with CEOs/Boards causes smarter boards to sell to

dumber acquirers right before the business is set to unravel. (a few times, I've shorted the acquirer, with good success).

So as if shorting wasn't hard enough, there's that!

SHOOT IT IN THE BACK

My first PM taught me two great lessons on shorting that have really stuck w me.

1) when you have a spicy short, shoot it in the back. Don't fight the fight and take it to the face. Wait for the crack, and step on it's neck (with TDOC, I didn't follow that lesson).

2) find the temporary tailwind, and wait for an imminent decel. Markets should be more

efficient, but the extrapolation bias in markets leads stocks to trade peak on peak & trough on tough (we've seen this in spades over the last 18 months). Wait for that temporary tailwind to cycle through for a few quarters, then when decel is imminent and valuation multiples are

peaking, the R/R on the short is at its best.

Two lessons that have helped me, a lot!

I'm going to write a follow-up thread on Short Idea Generation, but I'll give you a preview here. These are 8 buckets of shorts I look for.

1) Soggy / "quicksand" shorts -a secular headwind

2) Temporary tailwind dissipation
3) Hung guidance band-aid ripper
4) Profit evaporations
5) Liquidity trapdoor
6) Shorting the squeeze
7) Terminal value re-assessments
8) Emerging overhangs

Be back later this week with details on all 8 and 10 metrics I look for in a good short