CHAPTER 10
Guarding Against Risk
It's become common practice since the financial crisis for nearly all money managers—and those looking to hire them—to place significant emphasis on portfolio risk management. This renewal of focus on risk is far less pronounced in the best value investors, for the simple reason that guarding against the unexpected has always been at the core of how they think about investing. Oaktree Capital Chairman Howard Marks captured the general mindset nicely in this excerpt from one of his many classic investor letters, this one from 2009:
[I]nvestors shouldn't plan on getting added return without bearing incremental risk. And for doing so, they should demand risk premiums. But at some point in the swing of the pendulum, people usually forget that truth and embrace risk-taking to excess. In short, in bull markets—usually when things have been going well for a while—people tend to say, “Risk is my friend. The more risk I take, the greater my return will be. I'd like more risk, please.”
The truth is, risk tolerance is antithetical to successful investing. When investors are unworried and risk-tolerant, they buy stocks at high P/E ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap” rates.
There are few things as risky as the widespread belief that there's no risk, because it's only when investors are suitably risk-averse that prospective returns will incorporate appropriate risk premiums. Hopefully in the future (a) investors will remember to fear risk and demand risk premiums and (b) we'll continue to be alert for times when they don't.
The Baupost Group's Seth Klarman puts it even more succinctly:
Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
Guarding against risk is built into every aspect of the best value investors' strategies, from the ideas they pursue, their buy and sell disciplines, how they build positions, how they structure their portfolios, how they manage cash, and how they hedge.
MARGIN OF SAFETY
In Chapter 20 of The Intelligent Investor, Benjamin Graham, the patron saint of value investing, introduces the concept of margin of safety. Warren Buffett has called this chapter and another in the same book on responding to market fluctuations, “the two most important essays ever written on investing.” In its simplest terms, Graham writes that margin of safety comes from “a favorable difference between price on the one hand and indicated or appraised value on the other,” adding that “it is available for absorbing the effect of miscalculations or worse-than-average luck.”
Echoing but also broadening the concept of margin of safety, most top investors today cite the inherent risk aversion they build into how they identify, analyze, and choose potential investments—and, of course, what they pay for them—as their first and most prominent line of defense against risk.
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Our primary frontier of risk management isn't wide diversification, but the quality of the individual businesses, their balance sheets, and the people who run them. In the financial crisis the businesses we owned held up quite well, even if their stock prices didn't. That type of volatility is risk only if you're looking at a short time frame, which we aren't.
—Chuck Akre, Akre Capital Management
People don't believe business quality is a hedge, but if your valuation discipline holds and you get the quality of the business right, you can take a 50-year flood, which is what 2008 was, and live to take advantage of it. We incurred a markdown in 2008, and it was arguably just that. You may have to accept a bit more volatility with our fund than in a long/short fund, but we followed a down 2008 with a very strong 2009 and 2010 and would put our three-year returns up against anybody's. The key is avoiding businesses that get snuffed out at the bottom.
—Jeffrey Ubben, ValueAct Capital
Margin of safety comes from as many places as possible, but primarily from the strength and sustainability of the business model, low valuations relative to book value or cash-flow multiples, and undervalued hard assets or other assets on the balance sheet.
—Jon Jacobson, Highfields Capital
At the heart of value investing is the notion of mean reversion, that by paying a low multiple on a conservative margin you can win with the passage of time as the valuation of the business and the margins normalize. What can break that and cause mean aversion, though, are things like fading business models, expeditionary management deploying capital in a dilutive way, and adverse capital-structure contingencies. We make every effort to invest only in the universe of companies where those risks of breakage are as limited as possible.
—Matthew McLennan, First Eagle Funds
The consequence of our investment style is that we end up in good businesses, where the market isn't recognizing how good the business is or the level of cash it generates. Those tend to be fairly low-beta stocks, so even though we have a relatively concentrated portfolio—with between 15 and 20 longs at any given time—we haven't had very high volatility.
—Richard Vogel, Alatus Capital
Investing is often about knowing your strengths and we've learned that we're better at spotting profitable, unglamourous, undervalued companies than we are at identifying traditional turnarounds—by which I mean money-losing companies we expect to get back into the black. As a result, we set a guideline for ourselves that no more than 10 percent of the portfolio will be in companies with negative trailing 12-month earnings.
—John Dorfman, Thunderstorm Capital
I've always told people I have no idea what the market's going to do or when returns will appear in the portfolio. I don't think either of those is predictable. The best we can do today is to focus on companies with balance sheets to weather a credit-constrained world, business models that will be around for years to come, and valuations that are cheap enough to make the wait for recovery worthwhile. That's what we can control—the rest of it takes care of itself.
—Andrew Jones, North Star Partners
Our primary defense against risk, though, is to only buy companies that generate or are about to generate excess free cash flow, after capital expenditures and working capital needs. When problems develop, and they will, free-cash-flow companies don't have to take on short-term strategies that are not in the long-term best interests of the company to survive. They can make strategic acquisitions when others cannot. They can buy back their stock and raise dividends. They also often tend to be the companies that get acquired.
—Robert Olstein, Olstein Capital Management
Given our number of holdings [30 to 40] and our low turnover, we can devote 10 times the amount of time some others can spend on any given position, which means we should know the business better, reducing the possibility that things are going to hit us from left field. That depth of knowledge, combined with the quality of the businesses we want to own, is our primary risk-management tool.
—Eric Ende, First Pacific Advisors
Long periods of prosperity tend to breed overconfidence on the part of investors, which leads to a misassessment of risk. During times of excesses, we concentrate on reducing risk by holding uniquely strong companies.
—Ed Wachenheim, Greenhaven Associates
The most important way we manage risk is to avoid situations where credit risks can overwhelm the story. We'll take the risk that our assumptions about the business turn out to be wrong in fact or in timing, but we want to minimize the risk that value is destroyed or the story doesn't even get a chance to play out because of a balance-sheet crisis. If you put our portfolios against those of other value managers, we're typically in the lowest decile in terms of aggregate debt-equity ratio.
—Brian Barish, Cambiar Investors
After learning some hard lessons during the financial crisis, we instituted a rule that any ratio of total assets to shareholders' equity above 2.5 to 1 is an exception, which doesn't automatically mean we won't buy it, but each individual position size will be limited and we won't ever have more than 10 percent of the portfolio in such exceptions at one time. That's nothing more than a recognition that when you're wrong with a leveraged business model, the hit to the stock price can just be too fast and too damaging.
—Robert Olstein, Olstein Capital Management
BUILDING A POSITION
One way savvy long-term investors look to mitigate risk is by being in no rush to establish what they consider a full position in a new idea. That the share price can run away from them before they are fully invested is an irritant most are more than willing to accept.
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A full position is 8 to 10 percent of the fund's assets, but we typically work our way there over three or four tranches. At each step we're either gaining more confidence in the valuation and our ability to make a difference or we're not. For example, we generally don't meet with companies until we own a stake, so that's the first step once we've taken a position. As we gauge their response and validate with them and elsewhere how we're looking at valuation, we'll either sell, buy more, or sit on it to gather additional information. Working into positions this way helps manage risk.
—Ralph Whitworth, Relational Investors
We often take R&D positions in stocks [before completely finishing our research]. Action adds a sense of urgency to the work—there are so many things to look at in this business that things can fall through the cracks unless you force yourself to focus. Having capital on the books does that.
When we find out the company's a bad business partner, there are structural industry issues we didn't know about or maybe there's an earnings miss we decide isn't a short-term event—then we'll sell. But if every step of the way you get more excited by what you uncover, those are the companies that become 5 percent, 6 percent, 7 percent positions in the portfolio.
—Ricky Sandler, Eminence Capital
We like to live with smaller investments in a company for three to six months before making a full commitment. It gives us an opportunity to even better understand the company and its business while getting to know management and whether we're all on the same page. Sometimes the stock pops quickly and the valuation gets too high, or we lose some conviction on the attractiveness of the business, or it becomes clear that management and/or the board is not interested in developing a positive relationship. We very infrequently purposefully pick a fight, so we'll just move on. Our goal is that by the time we're ready to commit to taking a 10 percent-plus stake in a company we know the business cold and have bonded with management so that we're really in it together.
—Jeffrey Ubben, ValueAct Capital
Given that we're often buying into the teeth of a storm, it's rare that we feel we have to establish a full position right away. While some stocks may run away from us, we believe we've been hurt less by that than we've benefitted from averaging down as ideas in which we have high conviction first get cheaper, or by adding to positions as our conviction in the business and management grows.
—Peter Keefe, Avenir Corp.
After taking a relatively small position, we'll look to further establish our relationship with the board and management, which should allow us a deeper understanding of both the organization and the business. Management will say the business is going to do this based on how they're managing it, and if that happens, that's helpful, and if it doesn't, that's also interesting. The analytical process is highly iterative, which we consider a key way to manage risk.
—Jeffrey Ubben, ValueAct Capital
I've never been so disciplined that I hold off buying until 100 percent of the work is done. A workbench position gets built into a core position only when we have little or no question about the business, people and reinvestment opportunities. It takes time to learn how the business model really behaves and I've also found that it usually takes a long time to understand when management is really good. Many of the times I thought I knew right away, I was dead wrong.
—Chuck Akre, Akre Capital Management
CASH MANAGEMENT
How much cash an equity investor can hold in his or her portfolio is often limited by the terms of engagement agreed upon with investors. When that's not the case, opinions still vary widely among top investors on the extent to which cash is a valuable risk mitigator, or even a strategic asset.
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We don't manage our cash balance in a strategic way. Part of that is a business decision: people hire us because they believe we know how to find great unloved companies, not because we're clever going in and out of cash. Part of it is also just realistic. As much as I'd love to be in cash when the market gets hit, I don't believe I can get that consistently right over time. And if you make just a couple big mistakes on timing, it can kill you.
—James Shircliff, River Road Asset Management
By having a high cash balance, one is suggesting that he has some wisdom or knowledge about timing the market for which he or she should be compensated. I have none of that.
—Carlo Cannell, Cannell Capital
Many value investors have a very particular view of when things are cheap and when they're expensive and they should hold cash. They portray holding cash as a risk-reduction method. My view is that's just taking on a different risk. You're betting there is going to be regular cyclicality and things are going to get cheap again and you're going to be able to buy them. But if that doesn't happen as you expected, you're screwed. You'll end up like the guys that have been bearish for 20 years and don't have any assets any more.
—Bill Miller, Legg Mason Funds
We have opinions on overall risk that impact what we own, but we never have an opinion on the market. I've always found enough companies that meet our standards, so we remain more or less fully invested. I think timing the market is extremely difficult to do profitably. With individual companies, I can pinpoint the relatively few variables I need to get right for a thesis to work. When you start looking at the stock market's direction, there are so many variables that I can't even identify them all, let alone predict or weigh them correctly. My time is more productively spent elsewhere.
—Ed Wachenheim, Greenhaven Associates
People we greatly respect think about this differently, but if even in 2007 we could buy a company like Wrigley at 80 cents on the dollar, we think that's a lot more attractive than holding cash. We were getting a substantial free-cash-flow coupon, a strong balance sheet with net cash, and bottom-line earnings growing at double-digit rates. The way we look at things, even at 80 cents on the dollar, we'd expect a rate of return on something like that in the mid-teens annually. And that was available in, across the board, the priciest market I've ever seen.
—C. T. Fitzpatrick, Vulcan Value Partners
Our cash balance is purely a residual of whether we're finding enough to invest in.
—Jean-Marie Eveillard, First Eagle Funds
Our willingness to hold cash during fallow periods has enabled us to maintain a strict sell discipline regardless of whether we had anything promising to replace what we sold. This view on cash, combined with a truly long-term investment perspective, has also enabled us to avoid the gun-to-the-head mentality that pressures many investors to own less-than-stellar investments. The world doesn't end when we pass on a borderline investment that later works out; the danger we seek to avoid is the temptation or pressure to make too many borderline investments that later turn out badly.
—Seth Klarman, The Baupost Group
We usually hold less than 20 positions at a time, so no one would ever say we're a place to put all your money, but we behave as if that's what people have done. So we think it's reasonable to have some cash around for emergencies—as Buffett says, why risk what you need for that which you don't need?
We used to think having cash was a byproduct of not having enough to do. But the older I get, the more I see it as a strategic asset. It allows us to take advantage of those great opportunities that come up from time to time. We're just behaving like the companies we like to invest in.
—Bruce Berkowitz, Fairholme Capital
One big reason we like to hold cash is that my inherent nature is to feel something better to buy is always going to come along and I want to have the cash available to buy it. People assume they can always sell something to buy something better, but I don't like potentially selling into a lousy market when the liquidity isn't there.
—Steven Romick, First Pacific Advisors
Ben Graham always made the point that even if you thought you had a portfolio of very cheap stocks, if the market at the time was fully priced, you should have at least 25 percent of your portfolio in something other than equities, such as cash or bonds. To do otherwise would be to delude yourself that your stocks, no matter how cheap they appeared to you, would be magically immune if the whole market was to correct. I've always thought that made a lot of sense.
—Charles de Vaulx, International Value Advisers
If we can't find undervalued stocks we'll let cash accumulate, as we believe cash is a better alternative than owning an overvalued security. I'd argue that having the patience and discipline to save your cash for when the fat pitches come along is probably the most valuable trait an investor can have.
—Eric Cinnamond, Intrepid Capital
Periods of low returns have often historically been accompanied by higher volatility. That scares investors away, but volatility in a low-return world is a blessing for us, because there's more opportunity to buy low and sell high. That's one main reason we have 15 percent of our portfolio in cash, so we can pounce when volatility results in individual stocks being shot down excessively.
—Charles de Vaulx, International Value Advisers
When I was first starting out in the business, you could be more or less fully invested all the time. If there was a downturn in the industrial sector, you could sell the utilities you owned that were doing well to buy the beaten-down industrials. In today's market, everything goes up and down at the same time, so you don't have stocks going up to sell in order to buy the bargains. The best way to take advantage of a big market correction, then, is to have cash. In a normal time, we'll keep around 10 percent cash on hand for liquidity purposes. Given the state of the world today, we're closer to 20 percent.
We'll miss some profits when valuations are running high and we're raising cash. That's just not something we've ever worried about.
—Dennis Delafield, Delafield Fund
MIDAS TOUCH
Holding gold or other precious metals in one's portfolio as a hedge against macroeconomic risks is a common tactic among value investors—one that engenders, however, a good deal of debate.
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Gold is a logical alternative for those worried about governments' ability to manage their finances. If western political leaders adopt practices which result in devalued currencies, large budget deficits and rising inflation, gold to us represents a pretty decent store of value relative to currency alternatives.
—Robert Kleinschmidt, Tocqueville Asset Management
After the financial crisis we decided we needed to do a little bit more macro investing, hedging for potential strange outcomes within the system. Having a material stake in gold has been one primary way we've done that.
—David Einhorn, Greenlight Capital
There is a survivalist aspect to having such a big stake in tangible assets. As long as governments show such low regard for policies that support the real value of paper financial assets, investing in precious metals is about the only way to guarantee the preservation of your wealth.
—Eric Sprott, Sprott Asset Management
We don't look at gold as a commodity, but as a form of insurance against what Peter Bernstein calls extreme outcomes. In most circumstances in which worldwide equity markets would go down—and not just for a week or two—the price of gold would go up, providing a partial offset to the hits we'd take in our equity portfolio.
We don't have a blind commitment to gold. The time may come when we think the insurance premium is too expensive or we'll decide that the insurance is no longer required.
—Jean-Marie Eveillard, First Eagle Funds
Gold kind of scares me because very often the people involved with it seem to be slightly insane. My other problem is I don't know how to value it. Unlike an equity that supposedly has cash flow attached to it, or unlike a bond that has a coupon, gold isn't worth anything intrinsically beyond what somebody is willing to pay for it.
I have ended up buying it, however, because I concluded it offered opportunity under two extreme outcomes. If the world went into deflation, then gold would act as a store of value while the financial system disintegrated. On the other side, we know people use gold as a store of value during inflationary times, particularly in a world in which you're seeing competitive currency devaluations.
—James Montier, GMO
You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all—not some, all—of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value?”
—Warren Buffett (as quoted in Fortune)
HEDGING BETS
Beyond more common risk-mitigation methods such as diversification, holding cash, and owning gold, there are an ever-increasing number of strategies—under the broadly defined rubric of hedging—that investors can use to guard against general or specific risks in their portfolios. We focus here primarily on one of the more hotly debated of such strategies, the willingness to short individual stocks and indexes. While some market observers and practitioners consider shorting to be the devil's work, others can't imagine their portfolios—or the market in general, for that matter—functioning well without it.
To Short or Not to Short?
Shorting stocks obviously isn't for everyone and brings with it some unique challenges, not the least of which is unlimited risk of loss on any given position. Both avid proponents and opponents of the practice tend to agree on one thing: it's very difficult to do well.
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Without having a commitment to the short side, it's difficult to be offensive when you should be. The highest-return opportunities are available when markets are in free fall, but if you're getting shelled, you may not have the emotional conviction to be aggressively opportunistic, and you may not even be able to do it, because of redemptions. Being able to be offensive when everybody else is defensive, in and of itself, can yield excess returns.
A second element is that as true, committed short sellers, we have to be immensely skeptical, and skepticism is a terrific quality in a value investor. A key reason for our success is that we have a high batting average on the long side. We're better at avoiding mistakes because we're very attuned to those situations where value gets destroyed, or where it isn't really there in the first place, say, because of phony accounting.
—Ricky Sandler, Eminence Capital
Our view is that short selling may not in most years be worth the time and effort you spend on it, but you do it precisely for those years like 2008 when shorting not only offsets losses on your longs, but also produces capital that allows you to average down on the long side. A lot of people in 2007 gave up on short selling because it hadn't been particularly productive for a few years. In retrospect, that should have been an excellent sign something bad was going to happen.
Given all the stylistic differences of value investors, it's easy to forget sometimes what value investing is all about, which I would argue is margin of safety. That margin of safety doesn't just apply to your individual ideas, but also to how your portfolio is put together. The goal should be that in the middle of a storm that puts all the less-seaworthy boats at the bottom of the ocean, your boat, battered as it may be, makes it back to shore. Short selling helps you do that.
—Zeke Ashton, Centaur Capital
Both our shorting and activism have done a good job for us in tempering the downside. No one likes going through a crisis, but our shorts and some activist longs that moved independently of the market in 2008 kept us way ahead of the market and better able to respond to opportunities as they were created. On top of that, I think shorting is intellectually challenging and plays a valuable role in the markets.
—William Ackman, Pershing Square Capital Management
I believe the irrationality in the market generally tends to be more focused on the long side. As a result, I think that overall there are more incorrectly priced short opportunities than long opportunities. I [also] just consider shorting to be more intellectually stimulating. Like a lot of things in the markets and in life, the more intellectual argument is usually the negative one. There's something very satisfying about nailing an overpriced security.
—Robert Jaffe, Force Capital Management
We short because I think it is the most prudent way to manage a portfolio, from a risk perspective, and because I believe the key to successful long-term investing is to avoid losses. We also short because in certain subsections of the market it's easier than buying stocks. There are always classes of companies that are dying. If you really track the mortality rates of companies, you'd conclude that the market does not have the upward bias everyone thinks it does. The market is actually a carefully pruned garden.
—Carlo Cannell, Cannell Capital
We think shorting makes us better analysts. Charlie Munger says you really understand a company when you can articulate the negative scenario better than the person on the other side of the trade. We also think that from a business standpoint, if you've done all the work and conclude the negative scenario is most likely to play out, it makes a lot of sense to be able to short.
—Ric Dillon, Diamond Hill Investment Group
How would you judge an investing strategy with the following fundamental economic characteristics: (1) limited potential returns, but unlimited potential losses; (2) skyrocketing competition; (3) tax inefficiency; (4) aggregate net losses over its history; (5) The elimination of a significant source of income in recent years; (6) risk of asset repossession at creditors' whim? Having spent 15 years of my career doing nothing but short selling—with periods of great prosperity and other periods of fast, painful losses—I can argue with some authority that, as an investment strategy, shorting suffers from each of these characteristics of a bad business.
—Joseph Feshbach, Joe Feshbach Partners
We dabbled in shorting early on, thinking we should take advantage of the bad companies we uncovered as well as the good. In reviewing our shorts after our first year, we found that in each case we would have made money if we'd actually closed out the positions, but we hadn't. We were good at identifying the short ideas, but were terrible at trading them. Our batting average was just so much better with our longs that we decided we shouldn't devote the time to the shorts.
—James Vanasek, VN Capital
One general mistake we made in starting our firm was that we told ourselves that we should be hedging against macro concerns when that wasn't really our expertise. Short positions were never going to be a big part of our portfolio, but they took up an inordinate amount of time and added an inordinate amount of stress.
—James Clarke, Clarke Bennitt LLC
We do some shorting, but very little. The problem is that shorting requires timing, which isn't my greatest strength. I would guess that for all the shorts we've done over the past 25 years we're at about a $0 profit on them.
—Robert Olstein, Olstein Capital Management
Value Destroyers
Whether one shorts stocks or not, the characteristics short sellers look for in their best ideas are illustrative of what long-only investors should typically take great pains to avoid.
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The first and most lucrative category of short ideas are the booms that go bust. We've had our most success with debt-financed asset bubbles—as opposed to just plain asset bubbles—where there are ticking time bombs in terms of debt needing to be repaid, and where there are people ahead of the shareholders in the bankruptcy or workout process. The debt-financed distinction is important. It kept us from shorting the Internet in the 1990s—that was a valuation bubble more than anything else.
The next category involves technological obsolescence. Economists talk quite rightly about the benefits of “creative destruction,” where new technologies and innovations advance mankind and grow GDPs. But such changes also render whole industries obsolete. Disruptive technologies have two sides and always have. You saw it in the 1980s as personal computers wiped out the word-processor and minicomputer markets. What's playing out now is the transformation from an analog to a digital world. While that's created great fortunes like Google's, it's also wiping out whole businesses. Traditional music retailing was one of the first to start going. Then came video rental. Value investors will invest into these types of markets at their peril. Cash flows evaporate faster than you ever dreamed.
We also look for accounting irregularities, which can run the gamut from simple overstatement of earnings, often a gray area, to outright fraud. We're trying to find cases where the economic reality is significantly divorced from the accounting presentation of the business. It's not GE managing earnings—everybody does that. We want to see something way beyond that, where management is going out of its way to mislead. It could be the hiding losses in offshore subsidiaries like Enron. It could be abusing mark-to-market accounting as Baldwin-United and many others did. It could be Boston Chicken, a big winner for us in the 1990s, lending money to franchisees to cover losses and not reserving for the receivables. The biggest abuse in accounting today, often legally, is in acquisition accounting.
The last big one would be consumer fads. This is when investors—typically retail investors—use recent experience to extrapolate ad infinitum into the future what is clearly a one-time growth ramp of a product. People are consistently way too optimistic and underestimate just how competitive the U.S. economy is in these types of things: Cabbage Patch Kids in the 1980s, NordicTrack in the early 1990s, George Foreman grills in the early 2000s.
—James Chanos, Kynikos Associates
[Blue Ridge Capital's] John Griffin, one of the few investors who is really good at shorting, says you always want time to be on your side with shorts. Taking that to heart, our primary focus on the short side is on identifying secular problems that over the cycle are working against a given company. We try to steer clear of short positions in businesses that have relatively short business cycles, shorts based on valuation, or shorts betting on a bad earnings release.
We often find short ideas when all everyone talks about is how great demand is in an industry, while ignoring the supply side. We've seen that dynamic in some of the component markets for green technology, such as in the light-emitting-diode (LED) space. With the vast expansion of production capacity we can see going on, good luck making money in this business over time.
—Lee Atzil, Pennant Capital
We're looking for companies with weakening moats, often coupled with a resulting deployment of capital into areas in which they have no competitive advantage. Even better is when they're deploying not just excess capital, but leveraging the balance sheet to do so.
—James Crichton, Scout Capital
We don't short on valuation, but rather in situations where we believe a company is violating the law, or has misleading or inaccurate accounting, or has a potential regulatory problem.
—William Ackman, Pershing Square Capital Management
When we're short, we look for deteriorating industry conditions, company-specific fundamentals at risk, and liquidity issues. We will short a good company, even a cheap company, if we think reality will fall short of current expectations. The best way I've learned to short is by making mistakes on the long side—in value traps, for example—and then trying to recognize when others are making the same mistake.
—Larry Robbins, Glenview Capital
We primarily look for material disconnects between our view of economic earnings and the earnings that are reported and people are using to value the stock. It could be accounting related, so we pay careful attention to things like rising accounts receivable relative to total sales, cash from operations that is not keeping pace with net income, and decreasing returns on capital.
We also look for long-term structural declines—kind of the opposite of what we look for on the long side. Wall Street tends not to fundamentally mark stocks down until bad news actually shows up in the numbers. We'll ignore the supposed value today and focus on whether we think the “E” in a P/E is going to be materially less in three to five years.
—Ricky Sandler, Eminence Capital
We focus on what we call false hope, where stated company goals are unlikely or unobtainable. We've had success historically with single-product companies, often in the healthcare field. Management tends to be promotional, the companies burn cash because they're growing so fast, and Wall Street tends to love them because they're always raising money. When expectations appear to be that growth will never stop and that the success with one product will be replicated many times over, there's often plenty of room for ultimate disappointment.
—Robert Alpert, Atlas Capital
We have a motto, “buy cash flow, short cash burn.” If a business is burning cash, they're destroying value quarter after quarter. Two things generally happen. They have to recapitalize on unfavorable terms, which is good for us as short sellers. Or, they can't get financing, which, of course, is nirvana for us as short sellers because the stocks then usually go to zero.
—Zeke Ashton, Centaur Capital
When there is a cyclone of wealth transfer into an area, some of the participants in the fledgling industry will be real companies whose products and services will change the world. But there will also be dozens of other companies that are bogus and run by unscrupulous promoters. That's the subset of the market we're attracted to on the short side.
—Carlo Cannell, Cannell Capital
I have developed something called the C score, which is basically a six-variable method for searching out ideal short candidates that are potentially manipulating earnings. The variables are a growing difference between net income and cash flow from operations, increasing days sales outstanding, growing days sales inventory, growing other current assets to revenues, declining depreciation relative to gross property, plant and equipment and, finally, total asset growth greater than 10 percent.
There's a high probability that companies that score high on those six measures are actually manipulating earnings. By also requiring some measure of high valuation, say a price/sales ratio greater than 2×, we can imagine stock prices for the remaining companies going south quite fast.
—James Montier, Société Générale
It's very hard to short good-business-model, accelerating-growth companies just because you believe they're wildly overvalued. You don't often hear of investors making their fortune by shorting something like Google or Amazon. For value investors in particular, it's better to stick on the short side to broken business models, fads and frauds. There are usually enough of those to go around.
—Glenn Tongue, T2 Partners
We won't short on valuation—say, because Google is trading at 20× next year's cash flow when we think it should only trade at 15×.
—Steven Tananbaum, GoldenTree Asset Management
We're not playing for a multiple reduction, or a reversion to the mean for the industry. My biggest mistakes have generally been because I stayed with shorts just because they were expensive. The multiple game is a dangerous one—valuations can be crazy and stay crazy. We typically want to see something already or soon to be going very wrong. Our best shorts in the past 10 years, in fact, have been more in low-multiple companies, where we believed the earnings were illusionary.
—James Chanos, Kynikos Associates
One thing we like to do on the short side is to wait to see things start to break down before we get involved. Once something starts to crack, there will still likely be plenty of disagreement—reflected in the stock price—on whether or not the business is really broken.
—Alan Fournier, Pennant Capital
I guarantee that in every great blow-up there has been at least one big-name investor involved all the way down. Don't stop your work on the downside because you can't imagine so-and-so owner making a mistake. It happens all the time.
—James Chanos, Kynikos Associates
Portfolio Hedging
While many managers who short view the practice first and foremost as a profit center, shorting individual stocks and indexes also can play an important role in offsetting specific risks elsewhere in the portfolio. Some investors articulate well the strategy behind such efforts, but too often the explication is so complex that more questions are raised than answers given.
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To give an example of the type of hedging we do, we invested last year in Arkema, a specialty chemical company that was spun out of France's Total. It had all the classic spin-off dynamics and we saw it as an excellent opportunity to get in at a good price as a low-margin, neglected company was now going to be run by an independent management that could unlock the business value. At the same time, though, we didn't want to be exposed to a cyclical downturn in the chemicals business, so we shorted a basket of European specialty chemical companies that had twice the margins of Arkema and were trading at higher valuations.
—Jeffrey Tannenbaum, Fir Tree Partners
We keep our net exposure to the market in a tight band, usually from 0 percent to 25 percent. The basic rationale is that while we're confident in our skill as stock pickers, we're not confident at all in our ability to predict market direction. Another key aspect of our portfolio strategy is to limit exposure to exogenous variables. If we're long a chicken producer we believe is highly undervalued, for example, we'll pair that with a short position in a chicken producer we believe is overvalued because we don't want exposure to the price volatility of chicken, soybean meal or corn, commodities that dramatically impact the unit economics of the business. The more we can hedge against exposures that concern us, the more aggressive we can be in individual long positions based on our view of the fundamentals.
—Tucker Golden, Solas Capital
Our hedging falls into three primary buckets, which vary in emphasis over time. Typically the biggest one is a global market hedge, in which we use things like index options, index futures or credit default swaps to insulate the portfolio, to a defined level, from big market dislocations.
The second bucket is directly related to what we own, in which we'll hedge against a commodity price, a currency, or another industry player in a relative-value trade. In energy, for example, we're usually trying to isolate the relative value between stock prices and commodities futures prices. In those cases, for example, we'll short the oil and gas curve, to guard against the long bet getting washed out if commodity prices fall. Another example would be if we own Ford and believe not only that it's absolutely cheap but also cheap relative to GM or BMW, we may short one of those to hedge against a general auto-industry decline.
The last bucket includes shorts in individual stocks where we're trying to create alpha. It's been increasingly difficult to do this for a lot of technical and competitive reasons, which is why a lot of people have given up on it. We haven't given up, but as a percentage of the hedging we do it's currently the smallest.
—Jon Jacobson, Highfields Capital
Is Shorting Inherently Evil?
We don't share the general enmity sometimes directed toward short sellers, as if betting against stocks was somehow anti-American. Well-functioning markets depend on the transparent flow of information, which can be greatly hindered when critics are attacked not for the quality of their analysis, but simply for being skeptics. “The vilification of critics, be they short-sellers, journalists, or regulators, chills the free flow of ideas and analysis—indeed, chills free speech—by making it so darn expensive,” writes Greenlight Capital's David Einhorn in his book, Fooling Some of the People All of the Time, written about his experience shorting Allied Capital stock. “If posting an analysis on a website or making a speech gets you an SEC investigation, why bother?”
As in any category of investors, there may be bad actors who should be held accountable for misdeeds proscribed by law or regulation. There may be bad analysis for which the market tends to be a strict disciplinarian. Such safeguards should be fully sufficient to punish wrongdoers, while leaving the free flow of information intact.
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I have no problem with taking a negative view on a company, but as it's gotten easier (through the Internet and TV) and more economical (through options markets) to conduct bear raids, there's a much greater risk that short sellers can manipulate the markets and try to bring companies down.
—Martin Whitman, Third Avenue Management
From our experience, much long-oriented analysis is simplistic, highly optimistic, and sloppy. Short-sellers, by going against the long-term tide of economic growth and the short-term swells of public opinion and margins calls, are forced to be crackerjack analysts. Their work product is usually top-notch and needs to be. Short-sellers shouldn't be reviled or banned; most should be celebrated and encouraged. They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and enforcement agencies don't seem able to prevent.
—Seth Klarman, The Baupost Group
One general benefit of shorting is that it tempers volatility in both directions. Risk is created when markets get overvalued and short sellers help keep that in line. I'd argue that one reason housing got so overvalued is that until very late in the game everyone was on the same side of the trade, which created significant risk in the system. Short sellers also temper volatility on the downside – they're one of the earliest buyers when a stock crashes.
I'd also argue that the shorts who do good fundamental research play an important watchdog role. They have the resources to dig into something that a regulator might miss. Had people listened to Jim Chanos about Enron, or us about MBIA, or David Einhorn about Lehman Brothers, a lot of people's money could have been saved.
—William Ackman, Pershing Square Capital Management
It annoys me when management blames short sellers for a variety of ills and then tries to get Congress or the regulators to harass and vilify them. I long for the day when a management team, which has a well-known short seller publicly short its stock, starts its quarterly earnings call with a Q&A session with the short-seller. “We are now going to take all the questions which Jim Chanos, manager of Kynikos Associates, who is short our stock, would like to ask. Mr. Chanos, your line is open. Please proceed.” Wouldn't that clear the air?
—Timothy Mullen, VNBTrust
Short selling is now a lot more acceptable than it was, but it's still difficult. People question our motives and say things like “What's your vested interest? Aren't you saying that just because you expect the stock to go down?” Well, yeah . . . don't people who are long say positive things because they think a stock's going to go up?
—James Chanos, Kynikos Associates