Was asked this at a HF interview.
What is your thought process when determining good shorts and what are key items you look for.
Also, how do you determine what kind of position to take and how should you adjust/change your position if the market goes in your favor/against you favor (for example, cut position by half if share price rises 10%)?
Advice appreciated.
Thanks.
If the price rises 10% unless you have good reasons to stay short you might as well liquidate your entire position.
I'd say 5-7% is enough to stop losses, if it moves up to 10% I'd reverse it.
As for the main question, are hedge funds and financial services companies in general getting too used to the idea that the market must always go up that they lost the ability to go short?
When you say reverse it, what do you mean (buy?)
If you were short, yes. But I apply the same logic to the long position as well. 5% down liquidate. If it reaches 10% go short. It depends a lot on what you are trading anyway. What matters is have a rule and stick to it.
They've certainly made it increasingly difficult when central banks prop asset prices to no end -- no one wants to miss out on bull markets should the global CBs keep on pumping liquidity through the system, but neither do they want to take the hit when the efficacy of monetary policy falls apart and stuff really hits the fan. I'm of the view things will hit the fan, and it will be ugly, so I am happy to take highly informed short positions on companies whose financials look like a poster-child for accounting fraud, provided the business is weak as well. I actually release my short calls regularly for a list of subscribers.
I guess the answer would also depend on the strategy of the fund you are interviewing for, i.e. with a L/S fund you don't necessarily need your short positions to go down, as long as your long positions outperform your shorts. On the other hand, if you are talking e.g. global macro that might want to bet on a certain market going down the thought process is going to look very different. I'd imagine being able to recognize these differences and reflecting them in your answers would reflect favorably on you.
Btw this for equity L/S. Yes, agree with the poster above, if your position goes against you by 10% and you 'switch' your view, isn't there the risk that investors would take profits (hence you lose on your new position as well)?
Wouldn't it be more logical to reduce your position or reconsider the investment all together?
the idea that you would reverse your position if it moves 10% against you as a rule would likely get you thrown out of a fundamental l/s interview. but for fx or something maybe it's a good rule
Responding to LionHearts question on how to identify good short candidate - "What is your thought process when determining good shorts, and what are some key items you look for." Below describes my primary process.
There are numerous danger signs that could nearly allow me to write a book on the topic, so I will compress the answer to my key considerations and thought process when evaluating short candidates. I will also detail several key danger signs and/or irregularities I'd be looking for.
Stocks I seek to short often have good products, solid market share, perhaps even a strong brand name. But, one must always remember that a good product, company or brand does not always make a good investment. If I had the best tasting can of Pepsi in the world offered to me for $1,000,000 due to its special sugar formulation, it may be a great product, but it would certainly make for a terrible investment. Absent extreme circumstances, valuation determines whether a given investment is "good" or "bad" -- if buying at a price below that at which other participants are willing to pay (assuming market liquidity exists), then presumably, you're getting a deal (and thus making a good investment). Vice versa when the situation is reversed.
When trying to find stocks to short, I look for some common signs of fundamental business deterioration, coupled with a rigorous review of recent 10-Ks, 10-Qs, and other communications from management to identify irregularities in reporting or inconsistencies in statements made by the management team. Most of the time, I'm looking for questionable accounting practices, which can quickly distinguish a bad business from a good one.
Key Danger Signs I look for When Attempting to Identify Good Short Candidates:
1) High Executive Level or Management Turnover, Scandal at the C-Suite 2) A History of Restatements or Late Filings 3) Excessive Debt coupled with Deteriorating Operational Efficiency 4) Disproportionate Growth in Accounts Receivable relative to Credit Sales 5) Disproportionate Growth in Inventories relative to Sales Growth 6) Growing sales, EBITDA and even earnings without any cash flow to back them up - if EBITDA is growing, with the exception of a one-off period, cash flows from operations better also be growing, otherwise, something isn't right. 7) If the company is growing, capex/depreciation may be on the rise, but depreciation should be rising in absolute dollars and should ultimately reach a 1:1 ratio (roughly) with capex 8) Suspicious or seemingly unreasonable "non-recurring" or "one-time" add-backs to "adjusted" EBITDA and EPS, especially when they seem to recur nearly every period! 9) MANAGEMENT QUALITY, COMPETENCE & VISION is key to GOOD stock investments; likewise, management teams who don't know what they're doing when dealing with investors can be great short candidates. Look out for those who have historically tended to over-promise (through aggressive guidance) and under-deliver -- you'd be surprised, often times, these management teams (those who are known for big promises) are virtually 100% consistent in delivering unachievable guidance, and subsequently missing when earnings are released. One would think analysts would eventually catch on and ignore or highly discount management guidance, such that consensus would better reflect the most likely outcome, but, often they don't.
Also, I try to stay away from the momentum names and would advise others do the sam. These are companies who've become Wall Street darlings and are being pushed like crazy by Street analysts to buy, buy and buy more. Often these companies don't even make money, yet their market caps are far higher than those of the more boring (yet far more profitable), 30-year old industrial companies who've consistently generated positive cash flow and have brought reasonable if not generous returns to shareholders. One problem that frequently gets investors in trouble when shorting these posterchild momentum stocks is that of TIMING. Think TSLA -- although we all know the stock is wildly overvalued compared to the company's free cash flow potential over the coming ten years, it certainly isn't going to be sufficient to warrant the stock's current trading levels. Sure, they make great electric cars and perhaps some cool battery storage products, but that's not going to drive the required growth that's implied in Tesla's stock value today. That's the fundamental problem with chasing momentum names -- herding in and of itself breeds herding, driving a stock up and up, creating a bubble that brings the stock to unsustainable, often outrageous, heights. This can be quite problematic for the leveraged investor who's short a rising stock and continues to receive margin calls requiring cash payment to shore up the maintenance margin, drying up cash in the portfolio or requiring the sale of other positions to cover the margin requirement.
Shorting stocks can be a risky endeavor, so ensure your thesis is rock solid and backed by visible catalyst(s) that you're confident will materialize in the near-term (or, as long as you can tolerate, depending on the size of your portfolio, the cash position, etc.). Being forced to keep putting up cash to shore up the maintenance account time and time again can be painstaking, so much so that it has led to the demise of some of the most successful hedge funds.
Key items to identify deteriorating businesses and potentially good short candidates include companies with high-pressure to maintain sales or earnings growth, but look to be showing some early signs of business deterioration. Early signals of a deteriorating business can often be identified by comparing the income statement to the statement of cash flows. If sales, EBITDA, EBITDA margins and earnings are positive and growing, while operating cash flows are negative, and this continues for several periods, it's time for a rigorous review of the company's accounting policies. It is critical to look at trends over time, and ratios relative to industry ratios. Effective forensic analysis, whether used to identify outright fraud or other factors that perhaps don't bode so well for the company's future, requires you spend significant time sifting through the company's 10-Ks and 10-Qs, and I find earnings call transcripts can also be particularly useful.
Good read. Sitting for Level II in June and I have no idea how the hell you powered through for the CPA as well. Keep on keepin' on.
Thanks so much Emily for the input! Regarding point 4, what is this signalling?
Is it oftentimes aggressive sales practices or loosening of credit terms in order to reach a wider customer base so top-line revenue can be enhanced?
Can you typically look at mgmt.'s Allowance for Bad Debt estimates (assuming they're on the allowance method) and compare that to actual AR write-offs to see if there are any material discrepancies?
What are your thoughts on ATHN? I went through Einhorn's presentation that he gave last year. It was quite compelling given the business' deceleration of bookings, accounting changes for revenue and increase of capitalization of software expenses while R&D declined, high degree of mgmt. boosterism, and suspect gaps between GAAP and non-GAAP earning measures.
Regarding timing what's your opinion on ATHN; is it a momentum name or is it finally starting to teeter?
Great insights, appreciate it!
Industry deterioration is a relatively easy one but is often overlooked - you need to map out the value chain, some positions in the value chain could be leading indicators and others are lagging. Knowing how to identify leading indicators would be valuable (e.g., chip sales / order declines in mobile could mean tough quarters for smartphone handset makers, followed by potential decline in ARPU for mobile carriers, etc. etc.)
+/- 10% is irrelevant. What matters is if / when your thesis has changed. If a stock is +10% and the thesis is the same or stronger, we would typically add. In general larger funds don't really trade around for 5-10% positions because liquidity is always a concern. Generally looking for 30-40% downside or more for a short.
We're market neutral and do generate short alpha... Even in a rising market as long as the shorts go up by less than the longs we're okay.
From the trading/implementation side, you should remember that you actually need to borrow the stock to short it and the loan rate / availability should be one of your main considerations. Without accounting for borrow and loan rates, it's actually pretty easy to find compelling ideas. Trading the portfolio can be a lot more difficult though...
best advice i've ever gotten about shorting (from a portfolio manager who has a short only fund ( I believe there are still less than 25 funds out there)) is it's ALL about timing. I don't care how "right" you are you are going to weather a terrible storm before payday is definitely not worth the pain and hassle. He only shorts stocks with catalysts within a 6 month horizon is one of his key rules.
If you think about it, the markets are inherently long and the only way for you to make money is if the market sees some catalysts that quickly changes its perspective on the stock and it tanks
Short VRX, short oil miners... May 2016.
Let's visit this post few months down and see how good/bad I was :-O
could have sworn this said "Snorting"
thanks you so much for this post lionheart and emily's answer was really insightful too
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