The Art of Short Selling Chapter 2

Chapter 2 surveys the various hedge fund managers and what they look for in a short position.

Julian Robertson of Tiger Funds
Hallmarks:

1. Prodigious research
2. Bottoms-up Analytical methodology
3. A long-term time horizon

Robertson feels that short selling based on high valuation/ price alone is a bad idea. There must be a fundamental change in the outlook of the company or a major misconception by the stock-buying public.

Alex Porter of Porter, Felleman
Hallmarks:

Short positions reduce the risk to the portfolio of a long term market decline. The trick is to be short the stocks where financial accounting/ analysis shows that something is seriously wrong with the company.

1. Company based analysis
2. Management does not own much stock
3. Management is not realistic and forthcoming about their business
4. The company itself is over-leveraged or has a fatal balance-sheet issues.


Joe DiMenna of Zweig Funds
Hallmarks

Total short exposure is dictated by:

1. The number of attractive short-sale candidates their research uncovers
2. Net exposure to the market that their macro indicators suggests

5 types of short candidates
1. Frauds
2. Earnings disappointments
3. Hyped stocks where there are major holes in Wall Street's consensus expectations
4. Industry themes where macro-forces are negative
5. Deteriorating balance sheets

He generally won't short stocks with strong relative strength and earnings momentum solely on the basis of overvaluation.

Feshbachs
Hallmarks

They look for stocks with the following characteristics:

1. Stock prices overvalued by at least two times Feshbach-perceived valuation
2. A fundamental problem at the company
3. A weak financial condition
4. Weak or crooked management

The Feshbachs' hallmark is intense work and informational overkill. They start with fundamental analysis and add on information from a wide variety of sources. They don't short a stock unless they think it's going to drop in price by 50%. The reason is short selling is too risky for marginal plays.

The most difficult part of short selling is timing. They don't have an answer as to what is the optimal point to short a stock. They believe that one has to be certain of an important factor that other people do not see. Furthermore, the factor must affect the way the company is ultimately valued. One then has to see those mechanics begin to impact the income statement and the balance sheet, visualizing how the change evolves through the health of the company. Talking to competitors and suppliers reveals the climate and how long it might continue and gives insights into possible triggers. He cautions that the first position is not necessarily the biggest because stocks go up and you want to be able to average up.

Most importantly, you need to remain analytical when other people panic.

McBear
Hallmarks

1. Short ideas based on extensive credit work

2. Gathers important information by visiting companies. Feels Wall Street analysts are a poor conduit for company insights because they screen out relevant facts.

3. He feels that being a good listener asking thoughtful questions can learn critical facts about business trends.

4. The market is inefficient because there is always a bias to buy. Therein lies the opportunity for short sellers to make money.


Jim Chanos
Hallmarks

1. Chanos' specialty is solving complex financial puzzles.

2. Typically shorts large-cap financial companies with a high probability of bankruptcy.

3. Average holding period is 9 months.

4. No problems with buy-ins because of his use of large-cap stocks.

5. Does not visit companies and he uses Wall Street as a corporate emissary or interpreter.

6. Unique is his use of return on invested capital as a key financial indicator. The formula is: EBIT divided by average total capital (defined as total liabilities plus equity minus current liabilities plus short-term debt. In other words, the return on all interest-bearing liabilities plus equity plus deferred taxes and short-term debt.)

7. Financial companies are lucrative shorts because of the potential for rampant earnings manipulation.

My thoughts and Summary
In summary, I believe that on the short side, shorting requires more extensive and in-depth research. The refrain that one should not short a stock just based on valuation is heard over and over again. There must be major problems both on the operations side and on the financial side (over-leverage etc) of the company. Poor management is another requisite.