What is the research process for shorting a stock?

There are 3 main aspects of researching a company: quality, catalysts, and valuation. Each investment process emphasizes on 1 to 2 aspects. For example, value investors look for cheap valuation and quality business. Growth/momentum investors look for strong catalysts. GARP investors look for quality businesses bought at a reasonable price. Shorting a stock mostly focuses on the catalyst aspect.

Most shorts have a shorter time-horizon and can’t rely on rich valuation alone. They need to have a concrete short-term event that will drive the stock price down. So most research is done on researching the negative catalysts of the potential short. This could be talking to companies to get insights on their next earnings release, product launch. It could involve talking to sell side analysts about their expectations for the next earnings, vs. the company’s expectations.

Most company management don’t mind speaking to funds that short. Most funds are long/short, and management wouldn’t know whether a portfolio manager would speak to them with the intention to short or long. Funds that just short like Muddy Waters and Citron do have bad reputations and management avoid speaking to them.

Companies that like to avoid long/short funds do so for a different reason. They think that most long/short funds are short-term focused and buy/sell in herds. They drive up short-term volatility of the company’s stock. So some management teams prefer to have more holdings by long-only asset managers who are long-term focused. This gives more stability to the stock performance.

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