Fund Manager

This stock is a case study in shorts

Thu 04 May 23, 11:41am (AEST)
Henry Hill
Source: Livewire Markets (WaveStone Capital's Henry Hill)

Key Points

  • Short and long investing require different skill sets
  • Catalysts are necessary for short investing due to the market's upward trend
  • Being skeptical while identifying short positions can help in picking long positions

Investing short and long require two different skill sets. But that's not to say there isn't overlap between the two. Namely, the framework for assessing risks of shorts can be applied to longs.  

"Investors don't spend enough time thinking about what could go wrong, what are the red flags, what are the risks?" says Henry Hill from WaveStone Capital. 

"Whereas when you are looking for shorts, you are incentivised to think about why a stock would go down."

When it comes to shorts, Zip Co (ASX: Z1P) springs to mind for Hill. 

"I was never really a huge believer in the BNPL (Buy Now Pay Later) phenomenon. I never really understood how the unit economics would work on a 4% take rate with that credit quality of its customers, plus a real lack of differentiation between competitors."

In this edition of Expert Insights, Hill discusses the similarities (and differences) between going long and going short, and why Zip is a case study in the latter. 


Can you talk about the difference between long investing and short investing and how you use them in your strategy?

A lot of people think that short investing is just the inverse of long investing, but I actually think they're quite different games. And one of the first big differences is the need for a catalyst in short investing. And that's because markets usually go up. And the whole equity market complex, for lack of a better word - management teams, sell-side brokers, investment bankers, most funds - are incentivised for the stock market to go up.

I'll show you the incentive, I'll show you the outcome. Without a catalyst, the path of least resistance is up. Whereas when we think about longs, actually the absence of a catalyst is something that we like because no one will be looking at the stock. If someone says, "Oh, it's dead money," usually that's the time to be looking at a stock on the long side. And I think that the other element why you need a catalyst for a short is because undervaluation is a lot more self-correcting than overvaluation, because if a stock gets to a certain low multiple, you'll attract a certain type of investor, or you can distribute your cash flows in a big dividend or a buyback. 

Whereas if a stock gets to an extremely high multiple, no CEO is going to come out and say, "Oh, our stock is overvalued." That's the first. You definitely need a catalyst.

The second is the risk profile of a position. If a short goes against you, it becomes a bigger weighting in your portfolio and thus a riskier position. Whereas if a long goes against you, it becomes a smaller waiting in the portfolio, less risky. I think that risk profile makes it a lot harder to watch a short go against you than long. But it also really means you have to be very flexible. I think the hardest part of investing is knowing when to be stubborn or knowing when to admit you're wrong when a position goes against you.

And I think shorting actually amplifies that. You have to be both, more flexible and more stubborn at the same time.

Why does identifying shorts make you better at picking longs?

You do need to have a healthy dose of scepticism. And I do think looking for shorts makes you more sceptical, so philosophically, it helps in that regard. But I think there are a few reasons why it does help. And so, one I would say as a general rule, investors don't spend enough time thinking about what could go wrong, what are the red flags, what are the risks? Whereas when you are looking for shorts, you are incentivised to think about why a stock would go down.

You spend a lot more time thinking about what would tip the stock over, what are the risks, what are the red flags? I think that time spent doing that actually enables you to spot red flags or risks within stocks that you might want to own or the stocks that you do already own. 

I think the other element of shorting that helps you with longs is that the bull case is always laid out for you. Any half year annual presentation, there is the bull case. Management on any conference call will tell you the bull case. 

To find the bear case, you actually have to dig a little deeper. 

You have to go into the footnotes in the financial reports, you have to go and speak to industry contacts. So I think that level of work actually going against the grain does help you do a deeper level of detailed research.

Can you give us an example of a company you shorted in the past?

One company we did quite well out of shorting in 2021 and 2022 was Zip. I was never really a huge believer in the buy now pay later phenomenon. I never really understood how the unit economics would work on a 4% take rate with that credit quality of your customers, plus a real lack of differentiation between competitors. They had to keep spending money on marketing. 

Another element of payment industries is they usually coalesce around two or three large players. And for Zip, it was never better than the fifth or sixth player in the US, but that's where all the value in the equity was. 

And also COVID was a boom for these companies. The conditions were absolutely perfect. You had more spending online, you had more spending on goods relative to services. 

And third, and most importantly, you had governments giving money to their key customers, which A, boosted spending, and B, lowered the bad debt expense.

And even in those prime conditions, these companies still couldn't make money. 

You could see that as these prime conditions rolled off or got a little bit less prime, they would lose a lot more money. And we've seen that play out as we've moved through reopening. They've had to sell off some businesses and raise a lot of capital. And it'd be interesting to see what would be happening if Afterpay was still listed. I think they got very lucky selling to Square when they did because their issues are now just a small division of Square. But I don't think Square probably ends up getting $30 billion of value from that acquisition. But we'll see.

Why is successful investing just as much about being wrong as being right?

Investing is about two things. 

It's about making money when you're right, and it's about not losing as much money when you're wrong. 

And I think an acceptance and willingness to be wrong will benefit you in two ways, is one, you'll be able to take a certain amount of risk because we have to deal with uncertainty or being wrong when we take risk. 

And the second is, if you're okay with being wrong, I think that makes it a lot easier to change your mind when you do realise that you are wrong. Exiting a position quickly when you've realised that you're wrong and not hanging on hoping that things turn, I think, is a way to lose less money in the market.

And I think also on that note, you have to be willing to look wrong to make profitable investments. 

So I think the best investments ultimately begin with an idea that it is considered wrong by the consensus. And if you don't have an acceptance of being wrong or being willing to look wrong, you'll never make those contrarian investments. 

One stock that we got wrong to begin with was Treasury Wine Estates (ASX: TWE). So we did own the stock. But after China announced that they were going to implement tariffs on Australian wine, I think we thought that that could be an existential crisis for the business, but the actual tariff level hadn't been announced. And a lot of people were talking, "Oh, it'll be 40, 50%, but it'll be manageable."

But because it was a politically motivated act, our view was that that tariff would essentially bar them from the Chinese market, which was their most profitable market and the source of growth. And we thought that those tariffs could be a death knell for the company or at least the Penfolds business. And I think as we kept talking to management, as we kept talking to people in the industry, we could see that the brand power of Penfolds was actually better than we expected. And so we got back into the stock thinking that, you know what? The Penfolds business was going to be just fine even without their most profitable market.

And while it has been an issue for the company in terms of earnings, I think we'll look back in a few years time and say that maybe the best thing to ever happen to Treasury was getting locked out of China because they have made that Penfolds business a much more resilient business. They spent a lot more money marketing it all over the world. And I think it now probably deserves a higher multiple than it did when it was selling into China.

Learn more

WaveStone aims to provide capital growth over the long term and tax-effective income by investing in quality companies with a sustainable competitive advantage. For further information, visit their website or fund profiles below.

This article was first published for Livewire Markets on Thursday, 4 May 2023.


Written By

Chris Conway

Managing Editor

Chris is the Managing Editor at Livewire Markets and Market Index. His passion is equity research, portfolio construction, and investment education. He is also very keen on the powerful processes that can help all investors identify great opportunities and outperform the market, and wants to bring them to life and share them with you.

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