ROUND UP THE USUAL SUSPECTS (1)
Why is shorting not only good for markets, but should also be in all investors' portfolios.
You go down to your local supermarket but of late you have noticed that the price of shopping is just that bit more expensive than you remembered last year. You’ve got friends talking about how they are shopping at this new store that opened a few suburbs away and decide you should give it a go. To your surprise not only is it substantially cheaper but the quality is pretty good. This story is then played out across the rest of Australia one household at a time over 10 years until the company is forced to announce to investors that it expects to make a lot less than they thought they would. It is the story of the fall from grace of Woolworths.
This is the story of a cozy duopoly that was great for investors but was changing one person at a time. We all have heard of the idea that if you like the product you should buy shares in that company, but what about another approach, that is if the product is letting you down, how do you profit from that? That is where short selling comes in. It is a way for investors to “invest” in the poorly run or expensive companies they see around them.
Short selling is, and always has been, an emotional topic. It was partially banned during the crisis of 2008/09 and Franz Müntefering, head of the Social Democrat Party (SPD) in Germany famously referred to “International Capital” as “locust”.
Shorting, despite being relatively complex, has been around since the first stock as we know it traded in the Netherlands - The Dutch East India Company. A person by the name of Isaac Le Mairne shorted the stock in 1609, though in way that we (and authorities then) would deem unethical: via spreading rumors to drive down the price, for which he had his stock confiscated and died penniless and exiled! (2)
The term “short” has been in use from at least the mid-nineteenth century. Jacob Little was known as The Great Bear of Wall Street who began shorting stocks in the United States in 1822. Short selling was blamed for the crash of 1929 (which saw the implementation of the uptick rule which we will come to later). It was again blamed for some of the collapse of 2008 and partially banned in many countries, only to be allowed again. So there is no doubt that shorting has a colorful history. But sometimes in life first impressions are not necessarily correct and that is why short selling is allowed in most parts of the world despite populist calls after each crash to find a scapegoat, of which shorters provide a suitable looking candidate. What is it? Firstly, what is it? Technically, it is the borrowing of another person’s stock, for which you pay them a fee, to sell on market; receive the cash; and you owe them that stock that you have borrowed from them. If the stock falls, you buy the stock on market using less cash than you received and return the stock to the owner with you keeping the difference as profit (see Figure 1).
If this sounds a little complex, think of it this way. You’ve got some wine in your cellar you have collected but aren’t planning on drinking it any time soon. Your friend asks if he can borrow it from you for a few months and pay you for it. Your friend then sells the wine on market as he has heard that the grape glut will see prices fall a lot when the new vintage comes out.
In six months he then goes and buys that wine in a bottle shop at a lower price and returns it to you. You’re happy as you got paid for doing nothing and he’s happy as he made money.
I’d also note that “naked short selling”, which is where you put a sell order in the market with no stock to deliver (i.e. not doing the first part of step 1 above), just hoping that you can drive the price down, is banned/ illegal in most of the world. Nearly all places require the shorter to prove they have “borrowed stock” that they can deliver to the exchange, prior to placing an order on the market.
Rules such as this stop short selling from “driving down the price” as these rules make it such that if the price is to fall rapidly, it has to be selling from people who are already long the stock that causes it.
Whilst this idea of long holders driving down the stock price goes against what some media commentators may want people to believe (that shorting drives down stock prices) academic studies do not support that view.(3)
Why is it good for markets?
Whilst some investors may see the role of markets as to make them wealthy - we here at Morphic try to assist where we can! From a societal perspective, the markets primary role is to enable companies a route to raise capital.
A stock price that is as close to “fair” as possible is an efficient market (there is really no true price, more a range): this enables markets to communicate their views on the cost of capital to companies.
This process is called “price discovery” and is arguably the most important thing capitalism and markets provide to a society: the signal via price of what markets want to happen, such as higher prices to induce more supply or vice versa.
Shorting a stock is one way an investor can communicate his or her views on that business, just as going long a stock communicates the opposite. Over time, one of the two views will play out correctly.
To look at another market dear to our hearts in Australia and Sydney in particular – housing - here is a market that you can’t short. If people are concerned about overvaluation, there is no mechanism for this market to balance itself out, which increases the probability of a bubble if only one view can be held.
Now that is not to say that equities don’t have bubbles - just look at the “Dot Com bust” for example. But even here, some shorters were trying to bet against those stocks to “prick the bubble” earlier. Unfortunately for them, they fell foul of J.M Keynes maxim "the market can stay irrational longer than you can stay solvent" and in one (in)famous case were forced to shut their doors just before the peak.(4)
Could shorting be ‘wrong’ and do damage? There are some assets, like banks, who derive their value from their share price. A compete collapse in the share price could theoretically cause a bank run, thus destroying the bank.
In cases such as this in the 2008/08 crisis it can be argued shorting should be banned, though I do note that Lehman’s had gotten itself into a lot of questionable investments, it wasn’t shorters who forced them into subprime mortgages! Lehmans had a solvency crisis as well as a liquidity crisis.
Variations of shorting
If we move to looking at the implementation of short ideas, then shorting a stock on a standalone basis is just one variation of shorting. We at Morphic use 3 methods (Figure 2):
- Long the stock, short the market (say the ASX200): this just helps you make more money out of a good long idea without taking on as much day to day market risk. For example in the USA, there are some bank stocks which we think have excellent management and we are happy to own a lot of. So if we short sell the market against those stocks we can own more without taking as much risk on.
- Short one stock, long another: this is what is called a “pairs trade” and used to reflect a view of one management team being better than another, again, without taking on market/sector/country risk.
In some cases you aren’t even saying a company is ‘bad’, rather the spread between two isn’t priced correctly in your view. An example is that recently Morphic was long a US oil refinery called Valero, based out of Texas, but short another one called Hollyfrontier in the Mid West. It wasn’t that we loved the oil refining sector (if anything we didn’t like the sector), rather we though that inland refining companies near the shale revolution were vulnerable compared to those on the Gulf coast to changes in the oil market.
- The third and last type is the one we discussed above –short a stock. We actually do very little of this last one as it is incredibly difficult to do as over time markets and therefore stocks, tend to go up not down. An example of how we use it is to be short Woolworths but long the All Ordinaries Index. We discuss what some of the characteristics one looks for in a later section.
What should you look for in a short?
It is generally accepted within the long investing community that there are certain “factors” or styles that have added value over time, such as value investing; or buying quality franchisees or what others call “Buffett style investing”. One would think that naturally the best place to look for a short would be the mirror opposite of these stocks? Namely poorly run businesses or very expensive stocks.
The answer is actually no! This perhaps explains why most firms that have run money from the long side, once they start shorting, experience mixed success.
Below (Figure 3) is a look back at the performance of a portfolio of stocks since 2009, if one had chosen the “best characteristics” we described (the dark blue line). It has indeed added a lot of value for investors. On the other hand, chosing the “worst of" has underperformed the market, but only by a much smaller margin.
It would seem that most of the value that is added for long/short managers who do this, comes from their long ideas, rather than the shorts.
That is not to say that shorting “bad businesses” isn’t worth exploring, it’s just that it’s more nuanced than most people think. Our answer? Well, there are some things we prefer to keep to ourselves! After all, we are in the business of making money for our investors.
Why should I add them to my portfolio?
Having walked through the types and varieties of shorting that are out there, the question an investor could rightly ask then, is OK, but what difference does this make to my portfolio? The first thing to note, is that it is very difficult for investors to short stocks. The arrival of “Contracts for Difference” or CFD’s has opened up the market to retail investors, though it seems from positioning data most investors don’t take advantage of the shorting ability offered through them as most client positioning data suggests clients take long positions.
The most important addition is that empirically, (Figure 4), adding short positions to a portfolio reduces the overall volatility of the portfolio as investors that now have positions that make them money on days when the market goes down, but doesn’t come at the cost of lowering returns. In fact, long run returns are slightly higher.
The main problem individual investors face is that as long term investor, buying and holding is a good strategy as the winning positions get naturally larger, whilst the losing one’s get smaller (assuming one doesn’t add to them).
This is good portfolio management and the investor didn’t have to lift a finger to do it.
On the other hand, shorting is the opposite. A stock that you short at $100 goes to $50, which is great, but you now have only $50 in it. On the other hand, one you short at $100 goes to $200. Your equal weighted portfolio now has 4x as much money in its “bad bet” ($200) than it does in its good bet ($50)!
Compare this to a long example – the bad bet would be $50 and the winning one would be $200. The losing call is hurting the portfolio a lot less.
So active portfolio management becomes a lot more important now. For people who are SMSF’s this is going to be time consuming even if they are using CFD’s and happy with those tools.
For investors who want to use managers who can short, unfortunately the choices are more limited than the usual fund managers list. Fortunately, if you are reading this, you know at least one.
In conclusion then, why should an investor consider using short selling as part of investing?
It enables them to profit from more opportunities in the market via taking advantage of not only those things they see going right in the world around them, but also those things going wrong. It also has the effect of lowering the risks in their portfolio when stocks are paired out with a long and short together.
Secondly, as we discussed, it helps the market be more efficient. To ban shorters is to silence a point of view – people can listen to me offer my opinion on, say, Woolworths and dismiss it if they want. I will be judged only by the success or failure of my call on the company and I will lose the money if I am wrong.
Or as Warren Buffett said: “In the short run the market is a voting machine, in the long run it’s a weighing machine“.
About the author:
Joint CIO, Morphic Asset Management
(1) Casablanca the movie
(3) Bai, Lynn (2007). "The Uptick Rule of Short Sale Regulation - Can it Alleviate Downward Price Pressure from Negative Earnings Shocks?". U. Cincinnati Public Law Research Paper No. 07-20;
Alexander, Gordon J.; Mark A. Peterson (2006-03-15). "(How) Does the Uptick Rule Constrain Short Selling?". Social Science Research Network