How Hedge Funds Short Stocks: 4 Ways to Find Short Stock Ideas

By October 22, 2016Investment Process
stock market

Pokemon Go’s popularity exploded like a firestorm in 2016. The mobile hit leapfrogged Twitter in active users in just days after launch, and Nintendo’s stock price has risen 57% since. Expectations of further monetizing Nintendo characters are high. But let’s think about the reverse – could Nintendo be a prime example of how to short stocks?

Are the lofty expectations for Nintendo realistic, or is there irrational exuberance?

Pokemon Go is certainly not the first mobile game with high expectations, and it won’t be the last either. In 2013, a Japanese game developer called Gungho Entertainment released Dungeons and Dragons, wich monopolized mobile usage among Japanese teenagers. Gungho’s stock skyrocketed 2100% in just 5 months.

But as the game waned, Gungho’s stock price has dropped 80% since. And before Dungeons and Dragons, there was Farmville. A similar story played out with its developer Zynga.

Each case is different. Whether history would repeat itself in Pokemon Go is up for debate. But irrational exuberance is certainly one of the central theses in how to short stocks.

Good advice on how to short stocks is notoriously difficult to find. There are a plethora of volumes written on finding undervalued investments to go long. But what would make a good short stock idea? Is identifying unrealistic hype simply enough?

In this article, you’ll learn the 4 different ways to identify a short stock investment thesis:

  • Identifying irrational exuberance created by product fad, technology hype, and long cyclical growth.
  • Measuring working capital signals to pick up sales weakness.
  • Assessing the appropriateness of the company’s debt burden.
  • Evaluating aggressive accounting methods to judge management behavior.
  • Lastly, identifying negative catalysts for your short pitch.

Let’s get started on the 4 ways to Develop a Stock Short Ideas.

Short Stock Thesis 1. Irrational Exuberance

Value investing is about finding undervalued “cigar butt businesses”. What makes a business undervalued? It’s the overly pessimistic expectation of a business’ cash flow generation.

Shorting stocks is the opposite of that. A lot of times, it’s about identifying an overly hyped expectation that the market has created.

What creates irrational exuberance? There are 3 things that can generate unrealistic expectations: products, technologies, and business cycles.

Product Fad

A company’s valuation can rise rapidly following a successful product launch, because it creates market excitement about the company’s total addressable market. This might create a run-off in valuation that might be unsustainable.

Remember Crocs, the comfortable but ugly sandals that were all the rage in the 2000s? Expectations of the company’s sales soon reached euphoric levels, on the belief that Crocs would soon be the ambulatory device of choice for all homo sapiens alive.

Sell-side analysts kept revising its sales estimates upward. The company’s stock peaked in October 2007. But over the next 3 months, the stock corrected 45% on management’s sales guidance failing to meet expectations.

Technology Evolution

A business can have seemingly ironclad dominance with an unshakeable business model. Until the business model gets displaced with an entirely new process.

Video rental had been a stable business for decades. Blockbuster was the bellwether brand in home video distribution, with an interwoven network of retail stores and content relationships.

It wasn’t to be displaced. Until Netflix came online and disrupted video distribution in a fast and furious fashion.

Kodak had owned the personal camera market for over a hundred years. When digital cameras first came to market, they were seen as niche products that produced lower quality images.

However, before Kodak could adjust, the smartphone transformed the personal camera industry with convenience and sharing that trumped supreme picture quality.

The place to buy games used to be GameStop. Now gamers get instant gratification through the online distribution of downloadable content via the Xbox and Playstation networks. Would GameStop repeat the Blockbuster story?

Cyclical, Not Secular

During an abnormally long bull market, sustained growth in a cyclical market could be misconstrued as a secular growth story. Investors forget to discount any potential upcoming inflection points in the industry.

Think of the housing market in 2007. It had been on a 5-year tear since 2003. Real estate is fundamentally a cyclical market, yet “no end in sight” was the dominant investor mentality at the time.

When valuation runs to an irrational level, futures earnings and cash flows are likely baked into the stock price. The stock is priced to perfection, and the current price is only rational if the business achieves the already optimistic expectations. In this scenario, there’s little to no upside to the intrinsic value. This would be a great time to short the stock.

Wherever there’s irrational exuberance, there are potential stock short candidates.

Short Stock Thesis 2. Working Capital Signals

A company’s balance sheet is also an excellent place to look for short stock ideas.

Let’s look at account receivables, which are sales that have been made but with cash still due. Days of sales outstanding is a metric that measures the average number of days the company converts its account receivables to cash.

If days of sales outstanding is spiking for a consistent period of time, then there should be a reason behind it.

Perhaps the company is becoming more lenient with its outstanding receivables policy and is giving its customer better credit terms.

Why would a company do this? Maybe competition is getting worse. Or its customers might be facing tougher times and need more lenient terms.

Or worse, perhaps the company is becoming aggressive with its revenues recognition. Perhaps it’s “stuffing the channel” by shipping products ahead of actual demand to boost short-term earnings.

Whichever the reason, do research to find out why and whether it makes sense. You could potentially discover your short thesis there.

Similarly, track the company’s inventory. Identify the trend in the days sales of inventory.

This is a metric that measure how long a company holds its inventory before turning it into sales. The longer it is, the less productive the business.

If days sales of inventory spikes without management explanation, it could signal that inventory is not selling as well as before.

Why? Maybe competitor products are doing better. Or perhaps the company overestimated demand and overproduced, which would impact short-term cash flows and could lead to write-downs.

A large increase in both the days of sales outstanding and days sales of inventory is not a good signal. If you confirm that the company is fundamentally deteriorating after doing research, there lies your potential short idea.

Short Stock Thesis 3. Debt Burden

A healthy amount of debt can be jet fuel for a company, but an abnormally large debt burden can be dangerous to a business.

Ray Dalio of Bridgewater has been giving this message for a long time.

Companies over-lever for a reason. If leveraging is increasing, either the company is borrowing more debt or has declining EBITDA.

A declining EBITDA means the company’s fundamental performance is getting worse. Would a turnaround be near the horizon or would things continue to get worse?

If the company is simply taking on more debt, find out why. Is it using it to increase its existing capacity? Or it is borrowing to make acquisitions?

Delve into these projects to assess whether they make senses for the business. Did the company overpay for an acquisition that has no synergy with the existing core business? Is the capacity expansion right for the current demand environment?

Let’s think about oil drillers in the last energy cycle. Many oil producers have borrowed more debt to fund drilling projects, taking advantage of the low interest rate environment.

But when oil price tumbles from $100 to $30, it can be Chapter 11 sentencing for an over-levered driller. Debt is a double-edge sword.

Short Stock Thesis 4. Aggressive Accounting

Aggressive accounting is one of the worst forms of mismanagement. The most egregious practices border fraud.

At the same time, they are difficult to identify. It takes a strong background in accounting and a meticulous forensic study of footnotes in company filings.

Revenue recognition and below-the-line extraordinary items are two common places for accounting foul play.

Take revenues for example. What’s the company’s revenue recognition policy, and does it make sense? Is the company making lending transactions and recording cash received as revenue? Perhaps the company is counting supplier rebates as sales? What about releasing revenues from a prior merger as current sales?

Let’s also look at extraordinary one-time items. Is the company making reserves against bad investments? If so, is the reserve amount appropriate? If the company made a one-time sale of an investment, does the sale gain amount make sense?

In most cases, aggressive accounting does not equate to fraud. It could very well be within the parameters of GAAP or IFRS.

However, aggressive accounting could mean sub-par management. Why would management need to recognize revenues aggressively outside industry norm? Perhaps business fundamentals are getting worse relative to the competition? Ask yourself these questions and it could lead to your next short.

I recommend the book Financial Shenanigans by Howard Schilit if you are interested in learning about more examples of accounting irregularities.

Shorting Stocks is Not Just About Valuation

There’s one thing I want to stress. Unlike value investing on the long side, shorting a company is not just about finding a stock that’s overvalued.

Valuation alone does not make a good short. A stock price can stay irrational longer than you can stay solvent.

If you shorted internet stocks in 1999 based on valuation alone, your fund would’ve closed door before you get to the crash.

In the short-term, the market is a voting machine. Stocks trade on momentum based on newsflow, sell-side analyst recommendations, and earnings revisions. Therefore an irrational valuation can stay irrational for quite some time. Your short thesis might be theoretically correct, but it also needs to make you money.

Identifying a negative catalyst is very important in shorting. A negative catalyst is a tangible event that would make the market realize that the company’s fundamentals are deteriorating and its valuation stretched.

For example, you do all the work and find out that expectations for the upcoming quarterly release are too high. Then the earnings announcement could be the negative catalyst to send the stock downward.

Or perhaps through your research, you find that a business’ competing products are rapidly gaining share in the second half of this year when many existing contracts will be up for bidding. A sales announcement by the competitor could be the negative catalyst to drive a company stock down.

Short Stocks Summary

We went through 4 ways of developing a short stock pitch. Each is a signal that either indicates that the company has unrealistic expectations and/or deteriorating fundamentals.

Your pitch would explain why this is the case. More importantly, your pitch has to identify hard negative catalysts that would make the market realize what you already know.

This is it from me. If you have any questions, post it below and I’ll get right back to you.

Author Buyside Focus

More posts by Buyside Focus

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