Shorting and valuing a growth stock

Hey guys, I'm currently working on a short pitch for an upcoming HF interview, and would appreciate some advice, especially from the fundamental L/S guys out there. (Won't disclose the target, which was assigned by the HF, but willing to go into more detail via PM).

The target has been growing both top-line and cash earnings at phenomenal rates and is expected to continue to do so. Naturally, it is now trading at lofty valuation multiples vs. the industry, although also vs. where it has traded historically. I'm sure that the company isn't a fraud, and it's certainly not a management promote (if anything, management are rather conservative).

So what that leaves me with is a valuation short, and that makes me uncomfortable, since (as Hempton from Bronte Capital puts it), I'm suggesting that I can analyse the information out there better than everyone else.

I'm confident that the outlook for the company is not as rosy as the market believes, because of the following issues (which I feel the market is not considering sufficiently):
- organic growth is slowing down
- cost of growth is increasing substantially
- barriers to entry are low and there are some very capable companies that are looking to move into the industry
- suppliers are gaining the ability to tighten margins

However, I'm struggling with a couple of questions:
1) With a company where the consensus expectation is for earnings to grow upwards of 30% p.a. over the next few years (and let's be honest, no one can really predict this to a great degree of accuracy, let alone further into the future), how do you decide if the stock is currently fairly valued?

2) Although I have conviction on the issues listed above that will catalyse a correction for this company, I'm finding it difficult to put a precise dollar value, or timing on them. Should I be focusing all my efforts on this, even though I expect that the end result will not be very robust?

3) Whilst I'm not a fan of DCF analysis on long candidates, is there any merit in doing it for shorts? In the sense that you build an argument saying "these are the assumptions you need to believe in to justify today's share price", and then you proceed to demonstrate why those assumptions are invalid.

Really appreciate any advice or guidance on this!

(In case I get any hate, I'm aware that there's a somewhat similar thread out there at //www.wallstreetoasis.com/forums/developing-short-ideas, but it's more focused on idea generation, and a bit light on the valuation side)

 

Fair enough, but on the flip side, is a long pitch on an already expensive growth stock easy to accept? In all honesty, if you showed me this stock, I'd say there was too much uncertainty, I don't have an edge, next please. Unfortunately, not my choice.

Technically, the only rule is "no holds", so I don't absolutely have to do a short pitch on it. But I sure as hell am not going to go long, because believing in any further substantial upside requires going to stratospheric levels on every metric.

And regarding psychology, yes, that is precisely why I feel like I need a great deal of conviction on the analysis - because the psychology on a market darling growth stock can be utterly incomprehensible.

 

Oh...I guess I should have phrased it as asking if you have to to do a short pitch on THAT company. In that case, yes, it is a bit of a sticky situation. You could look like a typical market interested kid that thinks something is overvalued just b/c its gone up too much and fundies are sustainable. But then you could also look like a joe-schmoe kind of guy that thinks this company is the next Apple and has a lot more room to go up, even though its gone up 300% in the past year.

I wrote up a big piece on Telsa back when it was at $50, ripping it to pieces. But, I underestimated market sentiment and didn't think through the possible scenarios that eventually occurred (paying off the DOE loan, growing customer base, etc.)

I think the best way to go about it is do the initial write-up, be as bearish as a motha fucka as you can be, and then flip each "this is why they suck" point. From there, you can judge that risk/reward and see which side wins out.

I suggest you also read every ER report and financial news post you can get your hands on. Find what's bothering them about the company (should be an obvious few points) and consider what happens if those things go away. This will also help you to determine the sentiment out there right now and tell if people are at that "giddy" stage yet.

 
Best Response

First of all, from the issues raised in your question, I think you're considering the right things and are going to do a great job on this pitch. I hope they hire you.

Given your bullet points above, this doesn't sound like it's just a valuation short. I would be as catalyst-driven as possible around the things you think differentiate your view from consensus, because in the end whether or not the company is fairly valued in a theoretical sense today, the price is likely to decline once they start missing estimates (or estimates start being reduced). Management aren't the only ones who can do the promoting, and for growth stocks like this I find that sell-side consensus often matters a lot.

Focus on the factors you've identified and think about how they might ultimately be result in a change in sentiment. Does a well-financed competitor make a big entrance? Does sales & marketing reach some kind of saturation point where the diminishing returns become obvious? Is a major industry supplier likely to raise prices? Has the addressable market been penetrated further than people realize or is it smaller than the sell-side thinks?

On your specific questions:

1) One good way of thinking about valuing growth stocks is less focused on the right price for some percentage growth p.a. and more about a blue-sky scenario a few years down the road. Think about it like a biotech stock though the outcome may be less binary. What is the bull case here? They have some TAM and if the company executes on its plans they'll ultimately get to some level of revenue. What's the right margin for the business at maturity given the industry dynamics you've identified? And what would be an appropriate multiple for the mature business at that point? You can discount that value back to today at some rate of return to consider whether the current price is reasonable, or just think about it in a risk/reward context for where the stock might (reasonably) go if you're wrong.

2) Timing is the hardest part of short-selling. Have a good theory for why now is a good time, but in the end there's always an element of guesswork there and I would focus on your analysis. As to the amount of a decline, back to the valuation exercise, you should have a view on what the company is really worth and and idea of the potential return. One negative catalyst won't always get you straight back to fair value, but you should have an argument what fair value is.

3) On that note, whatever your preferred valuation methodology may be, use it. A DCF could be illustrative for the reason you cite. Multiples are just shorthand for a DCF anyway, in some sense. What do you think the right multiple should be? Why? Never hurts to show several valuation approaches. Does the sell-side use one that's unreasonable you can pick apart?

Just my two cents but hope it's helpful.

 

I don't think this is a sole valuation short given you mentioned growth is slowing. Do you know why growth is slowing and is it going to continue? I'm assuming analysts are doing their usual bullshit of whatever it was last year +x% since they don't know better.

If you want to see a short piece on growth slowing I recommend reading the sample research piece on FFIV by off wall street.

 

Most people who have successful shorts don't short high flying growth stocks. These are trading on sentiment and expectations, not fundamentals or business sense. Transaction wise, you will become insolvent before your short plays through. Just look at TSLA, NFLX shorts this year.

If you look at Einhorn - his shorts are melting ice cubes. Companies that are already on the decline, or in declining industries - that look cheap valaution wise, but everything looks cheap right before it goes bust. Chanos shorts things like Enron sure, but a lot of his shorts come from companies that over-earned due to a specific event or trend and such earnings is unsustainable (STX and CAT).

If you can find a specific catalyst for this stock in terms of why it'll go down in the future that is different. Take GMCR, Einhorn didn't time this right, but his catalyst about a key patent expiring and no one else recognizing it was one way to short a growth stock. But if it's pure fundamentals, I believe it's very risky.

 
thewaterpiper:

Fair enough, but on the flip side, is a long pitch on an already expensive growth stock easy to accept? In all honesty, if you showed me this stock, I'd say there was too much uncertainty, I don't have an edge, next please. Unfortunately, not my choice.

Technically, the only rule is "no holds", so I don't absolutely have to do a short pitch on it. But I sure as hell am not going to go long, because believing in any further substantial upside requires going to stratospheric levels on every metric.

And regarding psychology, yes, that is precisely why I feel like I need a great deal of conviction on the analysis - because the psychology on a market darling growth stock can be utterly incomprehensible.

They're probably asking because their own guys aren't so sure if it truly is a short can it doesn't hurt to see if you have insight!

 

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