Shorting Stocks: My Research Process & 7 Rules I Follow

thewaterpiper's picture
Rank: King Kong | 1,151

I short quite a lot at my current shop. I'd split my shorting into 4 buckets:

  1. Low quality companies that are misunderstood:

    These are typically misunderstood because some risk factor in the business model isn't fully appreciated by the market, or because analysts get too optimistic and project out constant (or accelerating!) growth and/or expanding margins. Example of this is retailers that are dependent on store growth who end up cannibalising sales which isn't in consensus projections. Sometimes primary research can almost be too easy (e.g. Restoration Hardware, which was priced as a premium retailer but ran endless promotions in 4Q15). But it's usually pretty hard. Ideas typically come from knowing the companies in your sector very well and understanding when expectations get out of hand.

  2. Thematic shorts:

    Typically more macro-based, e.g. trying to get short exposure to commodities cycle by shorting commodities-related companies; exposure to US minimum wage inflation by shorting labour-intensive businesses; etc. For me, this tends to be a by-product of macro research I do for my long book.

  3. Frauds and promotes:

    Typically smaller-cap and a lot of work, but some people are very good at this (Muddy Waters, Citron). Idea generation from various screens that indicate aggressive accounting (e.g. working capital, tiny auditors for relatively large companies, changes in accounting policy, etc.), and following lists of known stock promoters and crooked managers (but that's typically at the small and micro cap level). These are rarer for me, because to earn a good return on effort, you need fairly concentrated position sizes, which I don't like (see Position Sizing below).

  4. Hedging / pair trades:

    Sometimes we short to hedge specific risk factors in the rest of the portfolio, e.g. currency, macro, volatility, or just to manage our net exposures to a specific target. These tend to generate less direct alpha, but they enable us to put on more long exposure if we have long names that we have a lot of conviction in. Obviously you'd rather manage your net exposure by having "alpha-shorts" but sometimes you just don't have enough ideas.

Entering positions:
I'll expand on this below, but timing and trajectory is of the utmost importance to me when shorting. I tend to maintain a long list of names I'd like to short, and wait for opportune moments to build the positions. It means letting a lot of things go pass, but that's part of prudent investing in my view.

I follow a few rules when shorting:

  1. Never short high quality companies:

    Mainly because the sky is the limit on valuation when there is flight to safety, yield compression, or investors chasing quality growth. This is stuff like consumer staples and IG bonds in the last 2 years, and growth-y names like Under Armour (yes, some people made money shorting but plenty more got burned).

  2. Never short "story stocks":

    Similar to (1), when people get enamoured with a blue sky story, they can justify any valuation, even when fundamentals are totally out of whack vs. price. See: 3D printing companies. Timing the peaks on these doesn't fit my style but I'm sure there are people out there who do it well. Generally, going against the crowd isn't easy, and being 'contrarian' doesn't necessarily mean being smart (probably the opposite in most situations).

  3. Trajectory:

    The route to your target price is absolutely crucial. If a stock goes from $50 to $5 via $100, you'd have been stopped out way before you got to your target price and lost money. Shorts that go up work against you doubly, because gross exposure increases which means you often have to lock in losses as you trim your exposure to manage risk. I'll come across stocks that I think are long-term shorts, but pass because I think I'll get stopped out at a loss. This is why I find timing your entry on shorts is more important vs. longs (where you can double down if you're early). Options can be a way around this, but I find writing calls unattractive and expected volatility will usually work against you if you're buying puts in these situations. You're better off riding a short that's already on a downward trajectory (i.e. some aspect of the short thesis is fundamentally proven), particularly if it's a zero (or close to it), since the return from $100 to $10 vs.$70 to $10 isn't all that different.

  4. Catalyst:

    Shorting on valuation alone without a catalyst is a death wish because of (1) and (2). Also, I typically want my shorts to work a lot faster than my longs. This relates to (3). Since most stocks have positive beta and the market tends to rise over long periods of time, you are more likely to get burned if you hold on to your position for a long time. Also, the absolute return on a short tends to be lower (because the maximum is 100%), so you need to consider IRRs as well.

  5. Crowding:

    I suppose this is self-explanatory, but short squeezes are painful. Again, because you will get stopped out even if you're right (you can tell avoiding this is a common theme with me). Thankfully I haven't experienced one first hand (yet). I tend to pay more attention to the borrow cost rather than % float that's shorted, because I think borrow is a much better indicator of true liquidity. See: Volkswagen / Porsche. Fraud-y microcaps can be very easy to squeeze too. See: KBIO.

  6. Buyout risk:

    Buyouts are probably the worst outcome for a short, because you get forcefully closed out, and will never make that money back, even if you're right and the acquirer ends up writing down the entire acquisition years later. Moral victories are nice but you can't charge 2 and 20 for them. Many low multiple value traps are good shorts, but I always make sure I don't have too many in my short book because they can look cheap to some buyers. See: Green Mountain Coffee Roasters, Diamond Resorts.

  7. Position sizing:

    You typically want your individual shorts to be smaller than your longs, because their exposure naturally increases when you're wrong. This is one of the more irritating aspects to shorting, because you often expend a lot of effort for a not-very-large position size, so on an individual basis, shorting has poor return on effort. But from a portfolio perspective, it lets you be more long, so it increases your return on effort for your longs.

Right, this ended up being a far longer post than I intended, so apologies if it's a little rambling or disorganised. It's most definitely not a comprehensive guide to shorting, but I thought I'd just share some of the aspects from my process.

Mod Note (Andy): This very helpful comment by thewaterpiper was originally posted 7/25/16 in the thread What is the Shorting "Research" Process and received 20 silver bananas, so we thought it deserved its own spot on the frontpage for those who may have missed it.

Comments (26)

Dec 13, 2016

How difficult (impossible?) do you find shorting in the current market?

In a market structure where so many names are dragged along via ETF's and sector exposure, hasn't it gotten incredibly difficult to short names in the last few years? Just from my professional experience, so many short books have been getting slammed the last few years.

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Dec 13, 2016
zerojb34:

How difficult (impossible?) do you find shorting in the current market?

In a market structure where so many names are dragged along via ETF's and sector exposure, hasn't it gotten incredibly difficult to short names in the last few years? Just from my professional experience, so many short books have been getting slammed the last few years.

This. So much of this...

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Dec 16, 2016

I still like the idea of shorting the idiosyncratic risk (well researched weaknesses of a company).

In any kind of environment this type short works.
Noble Group
-aggressive accounting
- poor quality of financial reporting
- fatal business mistakes (qualitative)
- had repetitive capital Margin Call on its debt.
- negative operating cash-flows (this never lies).
- CDS curve predicates a default.
- The trader is shut down as well in the credit market.
- Finally the trader has infringed a cardinal law in commodity trading, can do whatever with investors but never, never alienate the banks.

Best Response
Dec 15, 2016

Shorting has been pretty horrible this year imo. So firstly you have the broad pro-equity factors you mentioned e.g. rotation into ETFs, which makes it tough to be short anything in the first place. Then you have other factors that have made stock-picking increasingly difficult on the short side, such as the vast quantities of PE dry powder on the sidelines that have bought out some heavily shorted stocks this year.

The sector exposure stuff has been bad too. e.g. Consumer Staples which has been a fundamental short for a while (slowing growth, saturation in EMs, peak margins). But 3G / Buffett are permanently threatening to buy any company in the sector; and chase for yield has made the whole sector a bond proxy anyway - so stock-picking becomes a very small factor in the equation.

I find myself spending more time on pair trades rather than alpha shorts right now. But that's partially because I feel like I don't understand equity markets right now, so I'd rather hedge out more risk, rather than try to express any strong views.

I do think the environment will get better for stock-picking; especially if rates do rise, and correlation between bonds and equities decreases. Inflation could be an interesting theme (esp. if US actually makes changes to fiscal policy and immigration), and there are lots of potential ways to express contrarian views on inflation via all its sub-constituents.

As an aside, some far more experienced people tell me that crappy stocks tend to rise the most in the last innings of a bull market - because there is nothing left to bid up - which makes stock-picking difficult in environments like these. But maybe that is just people fitting a narrative to reality in order to explain their underperformance. I haven't researched the subject enough to really know.

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Dec 18, 2016

As a friend reckons: "Pouncing on Glencore, even though you are right, would be a very long, expensive battle, unless you can skin the cat more covertly or indirectly via credit markets".

Dec 24, 2016

I think this is very interesting. I quickly searched for pair trades, and kind of understood it, but could you put into layman's terms what a pair trade is?

Dec 13, 2016

I don't know man, shorting Apple at the right time has been one of the best trades in 2015 and 2016. Doesn't Apple qualify as high quality company?

Dec 14, 2016

Can't you copy that post and replace "Apple" with any name that has gone up and down the last two years...

Hindsight is 20/20.

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Dec 15, 2016

Sure, I guess trading anything "at the right time" automatically makes it a good trade. Actually managing to do it is a different story.

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Dec 24, 2016

It's also been one of the best stocks to buy on any significant downturn.

Dec 25, 2016

Well duh. But one of the elements of OP's shorting strategy was ''never short high quality companies''. If we stick to that, then he's missing out.

Dec 14, 2016

Well structured, good post.

Dec 15, 2016

This is basically identical to an interview Jim Chanos gave

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Dec 16, 2016

You mention the difficulties of timing. Do you ever use technicals in timing?

I think you are too quick to dismiss puts. Yes, they are expensive, but you are paying to limit risk, like in the buyout scenario. Also, when volatility gets very low, puts can get artificially cheap. Put spreads are also sometimes interesting.

A bit more on trajectory. You talk about shorting on the way down being a better decision. I agree, but it's psychologically very difficult. Even though the gain from $100->10 is similar to the gain from $70->10, it gets harder to pull the trigger after a huge drop because you feel like you're late to the party, the valuation doesn't look as compelling anymore, etc. I'm pretty sure the answer is just "get over it", but thought I'd mention that.

Curious about how your due diligence differs in shorts versus longs, especially when it comes to management quality. Do you talk to managements when you are researching a short? If so, how do you probe without antagonizing them? How do you assess whether a manager is "crooked"? How do you assess when a manager has simply taken his/her eye off the ball?

Dec 20, 2016

Technicals: not really, but I do think about flows in the sense of 'what groups of investors are buying / selling right now, or in the future', which is where having good sellside (and buyside) relationships can be helpful. For instance, if a company goes ex-growth, but isn't cheap enough for 'value' investors (I'm generalising hugely here), that can be a tailwind for shorting.

Puts: I've just seen too many people make bad judgments when it comes to options, namely that they are far too eager to lose the option premium paid because it seems small relative to potential payout. It's like a sunk cost fallacy. Imo, the vast majority of people simply aren't good at making mental calculations with highly levered instruments - I don't think our minds are naturally programmed to do it. So when trading vanilla equity is my main job, I don't fancy my chances trading options against specialists who do it day in day out. Think of it another way, if you feel like a stock is a great short via puts, but not a great short via vanilla equity... it's probably not a great short. If you have great discipline, I suppose puts are a useful tool in the arsenal. It's just my philosophy to minimise the number of ways I can make mistakes.

Trajectory: yeah, not gonna sugar coat it, it's hard to short after you feel you've missed an 'easy' 20% gain. So this only really works for stuff where you truly believe the stock is massively overvalued. Other times, you've missed the boat, and it sucks, and you get over it / make up for it by having more ideas / learn from the experience and try to learn how to pull the trigger earlier.

Management: I look for very promotional management when shorting - the kind of management team that overhypes achievements and papers over cracks. I don't always talk to management - usually it's only to clarify or confirm my own research. The way I look at it, I'm never really shorting the management team - I'm shorting overvalued companies, and sometimes those companies are overvalued because the management team hasn't been completely transparent with the market. I don't love short theses that say 'management is destroying value' because that's easy to fix - all it takes is a big holder to replace management.

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Dec 16, 2016

Shorting penny stocks can never get better. Especially penny stocks with no catalyst/run on plain hype, manipulation, and euphoric buying=best shorts. Check out my short that I posted on instagram @wolfacademy. Called the dead top on $OPGN

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Dec 17, 2016

Great article. Thanks for taking the time to post!

What are your target and typical % returns?

Dec 18, 2016

SB for you. Shorting is no easy exercise, so it's encouraging to see a fresh approach.

Any books you recommend? From what I've gathered, most are garbage. Thanks.

Dec 18, 2016

The 2h interview of Barry Riholtz with Jim Chanos

Hedge-fund manager James Chanos of Kynikos Associates describes how he became a "fundamental short seller" in this week's "Masters in Business" podcast.

Early in his career as an equity analyst at Gilford Securities, he discovered that Baldwin Piano had morphed into a seller of insurance annuities and was also becoming a serial acquirer of other insurers. But the numbers didn't add up. Chanos kept asking questions, eventually leading to the discovery that earnings were being pulled forward, creating very misleading numbers. Chanos published his research, and the company's stock price doubled, before finally unraveling. At $9 billion, Baldwin was the biggest bankruptcy of its day.

Chanos eventually wound up at Deutsche Bank.** Despite his successful track record, some of the firm's clients complained about the young analyst's criticism. After a negative Wall Street Journal article, his contract was not renewed.** In 1985, he created Kynikos Associates, a hedge fund that now manages billions of dollars for institutional investors. Kynikos is the Greek word for "cynic."

Chanos has helped to uncover fraud at companies including Enron and Tyco and profited from them by short selling their stock. Other shorts included residential home builders KB Home and WCI Communities during the housing bust and bond-insurance firms Ambac and MBIA. He has also shorted companies that he deemed to be overvalued such as Sotheby's Auction House and Australian investment bank Macquarie Group. A 1980 Yale grad, Chanos currently teaches a course at the Yale School of Management.

Dec 18, 2016

Any blogs or books you'd recommend?

Already know about Hempton's blog and the books on Einhorn's and Ackman's shorts. Anything else you have to recommend on short selling would be appreciated.

Dec 20, 2016

From the original thread I posted before:

Not really... I've read the following which i think are somewhat useful, but none are a comprehensive guide to shorting, just tools to add to your arsenal.

Art of Short Selling - case-study based, some people really dislike it because it's not that intellectually rigorous. I think it's alright, especially the cases where the shorts failed / got burnt as they illustrate why shorting is a lot riskier. $50 might be a lot to spend on a bunch of anecdotes though. Really more of an introduction than a practitioner's text.

Financial Shenanigans - good place to start for fundamentals-based shorting

Creative Cash Flow Reporting - another more accounting/financial statement analysis-heavy text

Quality of Earnings - another statement analysis book.

Some of the old posts on John Hempton's blog are good, although heavy on Chinese companies i.e. heavy on the fraud-type shorts. I try to read a lot of old short pitches as well, some firms like Muddy Waters, Citron and Spruce Point disclose them publicly and I figure out what works and what doesn't post-fact.

I don't think there are really any books on the behavioural and portfolio side of shorting.

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Dec 19, 2016
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