Developing short ideas

I'll admit I know very little about shorting. Equity research is not known for its abundance of sell ratings. But, as I contemplate a move to the buyside, I am trying to learn.

It seems to me that successful shorts target companies with at least one of the following:

(1) Blatant overvaluation (e.g. Facebook)

(2) Failing business models (Best Buy, Newspapers)

(3) Companies with incompetent management, fraud, misleading accounting, etc. (Enron, Allied Capital)

But overvalued companies can stay at frothy valuations for years. And companies in dying industries are usually dirt cheap already. And finally signs of fraud may be dismissed by the market, assuming that you can find evidence in the first place. While reading through a 10k and discovering some sort of Enron-esque cover up sounds great in theory, I realize that I am not likely to see something the entire market is missing.

Clearly shorts require catalysts more than long ideas. Beyond obvious catalysts like "missing expectations" or "being investigated by the SEC", what are some of the more subtle catalysts you have used?

How do you guys develop short ideas? What does it take for you to short a stock?

Comments (84)

 
10/24/12

depending on your timeframe, the entire DJIA by Dec 2013.

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10/24/12

I think many L/S funds try to have a few core short ideas - along the lines of something that might come out of Greenlight (the things you highlight above). These tend to remain as longer-term shorts because while you don't know the timing, you feel pretty confident the stock will underperform.

Most short books (in my experience) have many names with little capital in each compared to longs. For these, read throughs are a great source, e.g., commodities falling, miners say they are cutting CapEx. The read-through is that CAT which sells mining equipment will face headwinds, TWI sells tires to CAT... etc. For these types of shorts to work, valuation isn't necessarily important. You need to have a sense of whether it's already priced in though.

Deceleration in trends is another area where I find shorts for shorter-term trends. It's tough to drum up buyers for a stock when sales growth is slowing, no matter what the valuation. I'd put in more work than simply running that as a screen, but it can be a good start.

I would also just add:
1 - blatant over-valuation is incredibly tough. The market decides the valuation so you need some catalyst to show them they are way off.
2 - failing business models often make better longs than shorts. PE firms can put in a little equity, a lot of debt, and get a big payback on a newspaper or other "mature/declining" type businesses.
3 - management and how they use cash is a good area to focus on. Frauds come along so infrequently and accounting aggressiveness (Allied) take a long time to prove out.

 
10/25/12

I decided to short FB like two days ago in one of those trading games on MarketWatch -__- oh wells. Didn't even know they put ads in their phone app and was basically making a guess so I could monitor them. Commenting so I can read the responses...

If your dreams don't scare you, then they are not big enough.

"There are two types of people in this world: People who say they pee in the shower, and dirty fucking liars."-Louis C.K.

 
10/25/12

Well explained grosse.

If you ain't gettin money dat mean you done somethin wrong.

" If you have built castles in the
air , your work need not be lost;
that is where they should be .
Now put the foundations under
them." - Henry David Thoreau

 
10/25/12

I think the easiest method would be to look for companies with aggressive revenue recognition policies, usually tend to be in the tech sector, and wait for some negative news on sales or a divergence between EBITDA and CFO. I'm no expert on this, just my own 2 cents.

 
10/25/12

I think it is also worth mentioning that you might not want to short companies that pay lots of dividends

 
10/25/12
triticus:

I think it is also worth mentioning that you might not want to short companies that pay lots of dividends

Obvi

If you ain't gettin money dat mean you done somethin wrong.

" If you have built castles in the
air , your work need not be lost;
that is where they should be .
Now put the foundations under
them." - Henry David Thoreau

 
10/25/12
triticus:

I think it is also worth mentioning that you might not want to short companies that pay lots of dividends

Obvi

If you ain't gettin money dat mean you done somethin wrong.

" If you have built castles in the
air , your work need not be lost;
that is where they should be .
Now put the foundations under
them." - Henry David Thoreau

 
10/25/12

+1 to u Rainmaker.

If you ain't gettin money dat mean you done somethin wrong.

" If you have built castles in the
air , your work need not be lost;
that is where they should be .
Now put the foundations under
them." - Henry David Thoreau

 
10/25/12

just follow the Einhorn

I'm talking about liquid. Rich enough to have your own jet. Rich enough not to waste time. Fifty, a hundred million dollars, buddy. A player. Or nothing.

See my Blog & AMA

 
10/25/12

In addition to what Grosse mentioned, I have also noticed that short ideas often originate from a retrospective analysis. After a share price has boomed (be it on valid reasons or not) some FM's are eager to find out why the company did not appear on their radar. They analyse the stock and, for instance, come to the conclusion that the company employs very vague accounting methods to recognize their sales of coffee, has very optimistic assumptions concerning growth rates (which company hasn't???), they also find that a lot of "sold" coffee is merely expiring in factory warehouses and so on.. Et voila, their short premise is born.

I also think there is a very fine line between 1) and some parts of 3). Overvaluation is always caused by some source of euphoria. Can you short euphoria? Yes. Can you short it profitably? That depends on what is causing the euphoria.

How easy can you prove investors that FB is a farce? Just take a quick look at their 20% increase on less than impressive earnings and you will find that is not that easy.
How do you disprove certain industry rumours? A lot of small biotech firms have been riding the "large pharma companies have so much cash they must be looking for takeover targets" phenomenon while deep down they are still the same companies with a (very) less than certain payoff. Can you short this? I actually do not know.

However, can you profitably short companies where you are sure that accounting methods are providing false fundamentals? Are they hassling with their coffee sales? Yes, short it and write an extended analysis (which hopefully gets featured). Are they using an SPV to buy commodities from company A which the SPV then sells back to company A at a higher price? Yes, short it and write an extended analysis. And, maybe most obvious, are they relying on house prices to go up forever? Yes, (big) short it.

 
10/25/12

You could check out the Beneish M-Score model to setup some screens for manipulation. Then plow through their statements etc.

papers_ssrn_com/sol3/papers_cfm?abstract_id=1998387

*Note that there are other factors that he has ommitted from this model(which is still a good predictor) which you could likely figure out and include.

Couldn't include full link... new user and all.. just replace the "_" with periods.

 
10/25/12

Speaking of short ideas... let me tell you how I missed one today:

SPR - makes components of airplanes for BA and Airbus

They fired a few top managers in their Wing division somewhat recently. The expectation whenever management is replaced is that performance is suffering (hence the firing) and a likely cut/change to guidance to clean the slate. Always blame all the bad news on your predecessors (Obama --> Bush).

SPR stock has been a pretty strong underperformer since then. Shorting on that announcement would've been a good bet.

BUT, all of the sell-side soon had out preview notes calling for a charge with varying degrees of severity. So, I didn't get short - SPR is generally cheap, you could debate that aerospace is a good sector to be in, and it seemed they'd announce the charge and the stock would go up (sell the news).

SPR instead announces a huge charge covering more than just the weak/expected programs. Stock is off 20% today.

I'll frame this as "over-thinking it", although had they announced an inline charge and the stock had gone up, I'd be kicking myself for not being long.

 
10/25/12

Just pick any Chinese company and it should be a good short.

Slightly off topic, John Hempton writes a decent blog pertaining to his thought process on shorts, http://brontecapital.blogspot.ca/

 
10/25/12

This is a very interesting conversation.

grosse, are those firms with highly diversified short books trying to ensure smooth performance, or are they using their short book as a hedge? It seems like even well-reasoned shorts have a lower success rate than longs, so I could understand diversification. That said, I also see a lot of managers buying index puts.

So I imagine Einhorn is atypical among L/S funds with his big short positions, as he can actually serve as his own catalyst?

And would your SPR example be analogous to shorting HPQ post-Meg Whitman hire? I thought they couldn't go much lower around $19 - then they announced a larger than expected restructuring charge and had a disappointing analyst day.

While it certainly depends on your estimated probability of the stock's collapse, what sort of upside do you demand from your short ideas?

 
10/25/12
West Coast rainmaker:

This is a very interesting conversation.

grosse, are those firms with highly diversified short books trying to ensure smooth performance, or are they using their short book as a hedge? It seems like even well-reasoned shorts have a lower success rate than longs, so I could understand diversification. That said, I also see a lot of managers buying index puts.

So I imagine Einhorn is atypical among L/S funds with his big short positions, as he can actually serve as his own catalyst?

And would your SPR example be analogous to shorting HPQ post-Meg Whitman hire? I thought they couldn't go much lower around $19 - then they announced a larger than expected restructuring charge and had a disappointing analyst day.

While it certainly depends on your estimated probability of the stock's collapse, what sort of upside do you demand from your short ideas?

Why lots of diversity - in my experience, it is as time consuming and payoffs are lower on shorts as they are on longs. Limited downside in a stock versus unlimited upside... plus markets tend to grind up over time. So most managers will spend 75% of their time on long ideas hoping to build a portfolio of x names they feel great about and 25% of time on a larger number of shorts, each of which they think will work but don't have the same level of conviction. Most investors are wired/trained to find winners.

Einhorn, from what we know about his portfolios, is atyptical. It could also be the case that he finds a small number of shorts he has really high conviction on which just happen to become public - then the perception is that he has a multitude of great shorts when in fact he might be very diversified.

Chanos' Kynikos Associates is a great example of being wired the other way. His firm (I believe) is always net short and that's a great differentiator when you are trying to attract institutional funds.

As mentioned above, John Hempton (Bronte Capital) and the guy from Muddy Waters have carved out a great niche in identifying China-based stocks to short. I know there was some controversy though where their allegations were crushing stocks while their claims were hard to prove. Still, good reads to hear about their process and what they uncovered.

Management changes - I wish I had some statistical data that would show the likelihood of management change followed by negative revisions, but the consensus is that it is high. Again, it'll get down to what gets priced in soon after the announcement as to whether it is a short.

Returns - the bar for me is actually quite low. If I think the risk/reward is favorable, I would recommend a short to my PM. The size of the position and how short of a leash the position would be on depend on the level of conviction.

 
10/25/12

just focus on finding bad / unsustainable business models, valuation shorts are generally not a great idea.

shorts that work well are mature industries in decline, once the dividend gets cut the story plays itself out v. quickly.

otherwise just follow around crooked management to whatever venture they start and short that.

 
11/4/12

What are some recommended business models and valuation charts that you guys like?

 
11/5/12

The Bronte Capital blog has been good at uncovering a lot of questionable things in the balance sheets of a lot of fraudulent chinese companies. I'd recommend going through their archives and seeing the types of stuff they notice.

 
 
11/5/12
 
11/5/12

I can't say I've had a lot of discussions with others on what they are short. Maybe it's some kind of fear that you could be squeezed out if your position was known.

Idea dinners are the one place that you'll get the full story.
Whenever I attend roadshows or company presentations, I chat up the other investors to talk ideas. Those are generally long ideas, but occasionally a short comes out.

Sell side brokers will know investors who are short and will probably know the high level points
Sell side analysts will likely know the rationale too, but won't be a great source of unbiased thoughts.

 
11/5/12

Conviction needed for a short > than for a long position

"After you work on Wall Street it's a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side." - David Tepper

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814 questions across 165 hedge funds. 10+ Sample Pitches (Short and Long) with Template Files. The WSO Hedge Fund Interview Prep Course has everything you'll ever need to land the most coveted jobs on the buyside. Learn more.

 
 
11/5/12

Not the best place to find a hidden gem, but still a great starting point is WSJ's Short Interest filters:
http://online.wsj.com/mdc/public/page/2_3062-nasda...

 
11/5/12

I worked four years for an equity L/S fund and nearly all our short ideas came from researching industry comps to our long ideas/positions. We had excellent returns on shorts, too bad the core long positions tended to wither or blow up and the fund went into the toilet.

 
11/5/12

My personal favorite is the good ol' Whitney Tilson "I bought it because Bill Ackman is a genius but I made my own powerpoint to share"

 
11/5/12

on a tangential note - shitty activists trying to hawk their fucked positions.

 
 
11/5/12
 
11/5/12

Any near terms catalyst besides the priced in growth assumptions??

 
11/5/12

I'd be looking for Chipotle's same-store sales to decline in the 2nd half. No way they can keep up that kind of comp growth they put up this last qtr. At the end of the day Chipotle is a mature restaurant concept that sells good burritos and trades for 50x earnings. WTF? Restaurants are super competitive with new/better concepts coming on all the time. Only thing that would disrupt my thinking would be if they pushed international (China, Europe etc) in a big way over the next couple years. They might.

I'd probably pair the short CMG with a long Potbelly (PBPB). Almost the same demographic yet look at the performance of the two stocks. This is not my coverage tho so not an expert, but if I wasn't restricted from shorting i'd be all over that...

 
11/5/12

I don't think CMG will make it in China... Mexican Food and China don't mix well lol..

 
11/5/12
jankynoname:

I'd probably pair the short CMG with a long Potbelly (PBPB). Almost the same demographic yet look at the performance of the two stocks. This is not my coverage tho so not an expert, but if I wasn't restricted from shorting i'd be all over that...

Sounds like a blueprint for disaster.

 
11/5/12

what would you do? scared to short CMG with the momentum going in and large price. don't want ot keep adding on $600 shorts

 
11/5/12
azndarkvader:

Fishing for shorts to hedge against the 20% correction hah

Hedging costs are currently very low.

 
11/5/12

yup i'm looking to go short on some stocks.. u have any thoughts?

 
11/5/12

When the time comes, I'll use PUTs to offset my one stock.

 
11/5/12

Obscure and original shot:

Ideally I should have posted this y'day and looked like a God.

Short: Dorian LPG (LPG) under delivering and way to small a fleet to command such a market cap. Also no longer the take over target of a bigger player (Avance Gas). LPG sector is where the LNG sector was 3 years ago and too much insecurity regarding new terminals and docks for exporting. Trading with a PE of 170.

My two zimbabwean dollars

CNBC sucks

"This financial crisis is worse than a divorce. I've lost all my money, but the wife is still here." - Client after getting blown up

 
11/5/12

Any thoughts on LONG TRLA short Z?

 
11/5/12

as much as I don't want to admit...BITA is trending lower. I have owned since 33 but realistically it should be in the mid to high 50's. :( holding on though as i see it going to 150 by 2017

 
11/5/12

Not short what is fundamentally the most sound company in the restaurant sector? It beats expectations quarter after quarter and it's clearly because its customers love it. I've never see a company that can grow its traffic after publicly announcing price increases.

 
11/5/12

its gotten ahead of itself though. overvalued but good company

 
11/5/12

TSLA, FB.. if there is a 20% correction (which i could see in the next year) you're pretty much throwin darts at a board, any short should be successful, but I could see some of these growth stocks taking the biggest hits..

 
 
11/5/12

LOL

Under my tutelage, you will grow from boys to men. From men into gladiators. And from gladiators into SWANSONS.

 
11/5/12

I would focus on those that will decline in value.

 
11/5/12

EMES, or any oil is a good one to short

 
11/5/12

Shorting is a piss poor use of capital most of the time. Especially for an investor, unless you're hedging.

 
 
11/5/12

why don't you post the report so people can give you some opinions on it? you'd probably get more out of that than from trading an idea.

 
11/5/12
Febreeze:

why don't you post the report so people can give you some opinions on it? you'd probably get more out of that than from trading an idea.

.

 
11/5/12
Febreeze:

why don't you post the report so people can give you some opinions on it? you'd probably get more out of that than from trading an idea.

I would usually look for some opinions/advice on it but I worked closely with my Analyst on the report who later initiated coverage and used the majority of my work (I've also shown it to professors).

Just looking for some short ideas (and other longs) to ponder going into the summer recruiting season.

 
11/5/12

http://www.wallstreetoasis.com/forums/top-longshor...

This is a thread in the "Traders Train" forum. People post their best longs and shorts, albeit no thesis behind the ideas is provided. This could be a good starting point for you... and you can lookinto the names and do your own diligence or potentially PM the person that posted it and ask them for guidance

 
11/5/12
 
 
11/5/12

5yr horizon, AAPL

 
11/5/12

Is it still possible to short Citi?

 
11/5/12

I second shorting apple. I see droid gaining market share especially with the problems iphone 4 is having. Plus, check this out hah:

http://www.bbc.co.uk/news/world-south-asia-10740817

 
11/5/12
TheBenevolent:

I second shorting apple. I see droid gaining market share especially with the problems iphone 4 is having. Plus, check this out hah:

http://www.bbc.co.uk/news/world-south-asia-10740817

Would that even be possible? How reliable and powerful would it be? I would be too skeptical to buy a cheap laptop (or pad). I would need proven success in rich countries. Even my laptop performs poorly.

 
11/5/12

do you all feel apple's p/e is too high?

 
11/5/12

Apple is trading at ~14X consensus 2011 estimates, a low multiple for a growth stock (amzn is trading at a forward pe of over 30).

Plus david einhorn recently bought in at ~$250 a share on the premise that aapls growth prospects are undervalued.

The iphone 4 problems are way overplayed by the media and I really don't see the droid gaining much share, especially when the iphone moves to verizon in jan 11 (rumored).

I understand some of the short arguments that aapl does not have another major product in the pipeline (that the public has been made aware of), but they have shown a track record of continually coming out with innovative products that exceed expectations plus the stock is cheap purely from a value standpoint.

Am curious to hear analysis by the shorts, by I think apple remains a buy at these levels.

 
11/5/12
iambateman:

The iphone 4 problems are way overplayed by the media and I really don't see the droid gaining much share, especially when the iphone moves to verizon in jan 11 (rumored).

Have no idea why you think that. Pretty myopic to be honest with you. Here are the numbers:

Total US Smartphone Subscriber Market Share

Sep 09 - Feb 10
Apple - 24.1% - 25.4%
Google - 2.5% - 9%

Feb 10 - May 10
Apple - 25.4% - 24.4%
Google - 9% - 13%

Source: http://www.comscore.com/Press_Events/Press_Release...
There wasn't any data before Sep 09, so I think the next report will essentially provide the direction for the next year in the smartphone space since during the last 3 months, the EVO, IPhone 4, Droid Inc and Droid X were all released. Plus I'll love to see how the iPhone moves during a launch month. If iPhone users are just upgrading, or if they are getting new users. If AAPL can keep their margins in the upcoming years, they are fine, but are in big trouble if they fall.

I'd short NOC though. Obama is going to decrease defense contracting and their 50 day just crossed over their 200.

 
11/5/12

[/quote]
There wasn't any data before Sep 09, so I think the next report will essentially provide the direction for the next year in the smartphone space since during the last 3 months, the EVO, IPhone 4, Droid Inc and Droid X were all released. Plus I'll love to see how the iPhone moves during a launch month. If iPhone users are just upgrading, or if they are getting new users. If AAPL can keep their margins in the upcoming years, they are fine, but are in big trouble if they fall.
[/quote]

The Evo contends for sprint, droids for verizon, iPhone for AT&T. What happens when the iPhone goes on sale for Verizon, which it is rumored to do in January.

 
11/5/12

not saying your wrong...but I beg to differ. I would short apple...Check out samsung's new galaxy S. Just launched last week or so and is, in my opinion, the closest comparison to the iPhone 4. Plus androids 2.2 system will be released in the near future making it an even better buy and insurance plans are much better as well as the fact that it is carried by almost every major carrier. I think this will eventually rival the iPhone

 
11/5/12

Listen, I have been a windows guy forever. I was a huge blackberry crack head. Then I got an Iphone. Absolutely loved it's simplicity and swiss army knife functionality. Now I have an Ipad. I am seriously considering venturing into an Apply laptop now. The thing with Apple's mobile devices is that they are gateway drugs to bigger Mac purchases. Considering that Mac has such a small share of personal home computers this gives them great growth potential.

You know who I think you should short? RIM. They are the next Motorola or Palm if you ask me. More and more businesses are allowing Iphones which will cut into BB's core market.

Short Rim

Long AAPL

Masters in Finance HQ - The #1 site for everything related to the MSF degree!
MSFHQ

 
11/5/12
AnthonyD1982:

Listen, I have been a windows guy forever. I was a huge blackberry crack head. Then I got an Iphone. Absolutely loved it's simplicity and swiss army knife functionality. Now I have an Ipad. I am seriously considering venturing into an Apply laptop now. The thing with Apple's mobile devices is that they are gateway drugs to bigger Mac purchases. Considering that Mac has such a small share of personal home computers this gives them great growth potential.

You know who I think you should short? RIM. They are the next Motorola or Palm if you ask me. More and more businesses are allowing Iphones which will cut into BB's core market.

Short Rim

Long AAPL

I agree. I also think RIMs new slider won't take off and BB OS6 is only playing catch-up to the other players in terms of functionality.

 
11/5/12

If anything, I would think Apple would split but I doubt that will happen. The company has roughly 250 billion in working capital so I don't see a need to raise funds as R&D can only suck up so much money. In 4 years, they went from not having any phones available to being the best selling smart phone company in the world. Not bad for only allowing it's phones on 1 shitty network.

There is so much more for apple to do. The iPad/iPhone are restricted to AT&T. Imagine how much more money they'll make when they expand to Verizon and Sprint. The droid is just something to pacify verizon customers until the iPhone is available. Then Nokia may start to regret the acquisition of motorolla. Not only are they constantly sold out of iPhones and iPads (LG can't make the screens fast enough to keep up with demand), but those are items that are at a premium cost compared to their competitors and we're still in a depression.

I'm just curious as to why Apple doesn't pay a dividend with such a high market cap.

 
11/5/12
schifm08:

I'm just curious as to why Apple doesn't pay a dividend with such a high market cap.

Apple is a growth stock. Many growth names prefer to pay out small or no dividends in order to reinvest more in their own growth. If and when Apple ever sees dramatically slowed growth, it may start to pay a dividend to attract interest in its shares. People talk about how much cash Apple has on hand but there doesn't seem to be a compelling reason to pay dividends right now with such long interest in the stock already. If their shares dip at some point I could see the company buying some back.

 
11/5/12
schifm08:

I would think Apple would split but I doubt that will happen

lol

"My name's Ralph Cox, and I'm from where ever's not gonna get me hit"

 
11/5/12

Another reason why I wouldn't short Apple - they continually attract top talent from both new and experienced hires, and that's not gonna change anytime soon.

 
11/5/12

TSLA coz they're not even close to making money

 
11/5/12

Shorting MCO, NFLX, OMX, SVU

OMX and SVU have been great shorts

Looking to short western REITs as well. Still doing research.

 
11/5/12

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11/5/12
looking for that pick-me-up to power through an all-nighter?