Time for contrarians to be rewarded?

By Hamlin Lovell, NordicInvestor

The odds are massively stacked against short-sellers, from multiple angles: history, statistics, mathematics, market participants’ incentives, corporate activity, and technical factors, not to mention regulation. These were explored in the PhD thesis of Jupiter’s Head of Strategy, Absolute Return, James Clunie, entitled “Indirect Short-Selling Constraints”.

“Conceptually, short selling is a mug’s game” enumerates Jupiter’s Head of Alternatives, Magnus Spence. Equity market behaviour is to rise gradually over long periods, and fall sharply over short periods. Short selling the overall market has only been profitable during those market corrections. Company management, asset managers, long term savers, and brokers, all want to see prices go higher. Mathematically, the maximum profit from a short is 100% whereas the maximum loss is theoretically infinite. Shorts can fall prey to takeover bids. Technical factors are also unhelpful, as short sellers pay rather than receive dividends – and incur stock borrow costs that can be as high as 75% a year (for Snapchat owner SNAP, which Jupiter shorted for a few days. Usually borrow costs are below 1% a year). Overcrowded short positions make it difficult or impossible to obtain borrow, which can anyway be recalled by lenders in the event of a short squeeze. Regulation adds another risk in that short selling in general, or of particular sectors, has been banned during financial crises. (The ban on shorting Greek bank stocks imposed in 2015 is the most recent one that springs to mind).

Yet Clunie feels that mid 2018 could be an opportune juncture for skilled and experienced short sellers. Spence sees irrational optimism and bubbles in some quarters of the financial markets. In big picture terms, growth stocks have massively outperformed value stocks, expanding the valuation gulf between them to levels last seen at the 1999 apex of the TMT bubble, or on the eve of the great crash of 1929. Spence is of the opinion that the craze for passive, index investing has also contributed to a momentum-driven bubble within indices, which may see an accelerated change of direction. Any investor with a contrarian slant must be interested in exploring a strategy that has faced headwinds for the past ten years. And short selling is a useful portfolio diversifier versus most other strategies, which are long-only or long biased.

While maintaining these high convictions, the team’s modus operandi is to manage its short book in a cautious and controlled fashion, with strict rules on position sizing and diversification. “We want to stay in the game during a long gradual market rise” explains Spence. Thinking tactically, in a game theoretic framework, it is important to be aware of other market participants’ positioning. “We understand the ecology of shorting – what others are doing, is the share register weak or robust” he adds.

Clunie’s strategy has not held shorts above the threshold (of 0.5% market capitalisation) that requires regulatory disclosure in Europe, and US shorts do not normally need to be disclosed.

“We make some disclosure of short positions in annual and interim reports, but generally we see a competitive advantage in not publicly disclosing short positions, since competitors could carry out predatory trades against us” explains Spence. That said, several examples can be discussed.

Bad companies and bad stocks

Thematically, Clunie can split his short book into two categories: “bad companies”, and “bad stocks”. Bad companies may be victims of disruptive innovation, operating in sunset industries, or they could simply have over-extended their balance sheets with excessive leverage. Spence realises that an eclipse is often already reflected in share prices, so the portfolio managers try to focus on information over and above what is already factored in. Commodity producer and marketer, Glencore, was an indebted company that proved a profitable short for Clunie, between July 2014 and September 2015, when the share price fell by around 80%.  Sometimes, Clunie has been short of companies that eventually went bust, such as indebted renewable energy firm SunEdison, but terminal shorts are rare.

More common are bad stocks, which might be very good or okay companies that have become overvalued in Clunie’s view  – relative to the sector, peer group or history. McDonalds is an example where Clunie thinks that both the share price and consensus sell side forecasts imply unrealistically high expectations for profit margins. Jupiter can short companies in any industrial sectors and currently some agricultural machinery companies, including those providing vendor finance, are viewed as vulnerable to rising rates and to China imposing tariffs on US foodstuffs.

Crowded shorts and TESLA

“Tesla‘s valuation is very expensive by any metric in our view, it is burning cash, and it will likely struggle to hit its production target of 5,000 units per week of model 3, without borrowing much more” says Spence. Founder Elon Musk, who brands his critics as “haters”, has recently, and somewhat bizarrely, accused employees of sabotaging production and been forced to shut down some solar facilities that were, controversially, bought from a related party. The team are well aware that Tesla is a crowded short with 30% of the stock out on loan, and has an evenly balanced view of crowded shorts. “On the one hand, academic research shows that heavily shorted stocks do tend to underperform over time; on the other hand, we are cognisant of the risk of short squeezes. Overall, the fundamentals look so poor to us that the short in Tesla seems justified. The team size the short at around 1.5%, so that rallies such as a 20% rise in June can be stomached. “We source stock borrow through a number of prime brokers, and stick to more liquid mid-caps and large caps” says Spence.

Single stocks, derivatives and factor risk

Nearly all of Clunie’s short book is comprised of single stocks. Synthetic shorts via CfDs are the main instrument of choice for UCITS funds, though listed or OTC put options can also be used from time to time. The vast majority of exposure is in equities, where the team’s main expertise resides (though sometimes long positions can be expressed through convertibles e.g. in 2009 or credit e.g. in 2012 when extreme value is perceived).

Thinking about the portfolio holistically, Clunie may use derivatives to hedge certain risks. “We are short of the US market overall, because we are short of expensive stocks based on bottom-up analysis, and so have bought some very cheap out of the money call options on the S&P 500 to hedge the risk of a blow-off top in the market” says Spence. Conversely, Clunie’s strategy owns gold to hedge the risk that a cataclysmic crisis could hurt the value financials that populate part of its long book.

Viewed through the prism of factor risk, the team estimate that the overall portfolio is somewhat short of interest rate duration risk because shorts tend to be “jam tomorrow” stories with distant forecast cash-flows, while longs are already generating cash-flows. The book is also short of credit risk to the extent that it is short of companies whose business model depends on vendor financing.

Products short selling

Clunie expects short selling to generate absolute profits during downturns or even in sideways but volatile markets. In rising markets, the short book is expected to underperform broad equity market indices. Since joining Jupiter in September 2013, Clunie has generated annualised alpha of 3% on the short side.

Jupiter pursues short selling in two strategies today: the global equity long/short Jupiter Global Absolute Return fund managed by Clunie, and the European equity long/short, Jupiter Europa fund (SICAV), run by Danish national, Mike Buhl-Nielsen, who joined Jupiter in 2006.

Subject to regulatory approvals, Jupiter plans to launch a UCITS-compliant US equity long/short strategy, to be managed by Darren Starr, who was hired in April 2018.

Idea generation benefits from an informal discussion amongst these and other portfolio management teams at Jupiter, which include UK, US, European and Japanese equity specialists, as well as the award-winning Ecology team managed by Charlie Thomas, who focus on environment and sustainability issues, (and who Nordic Investor interviewed for a feature on ESG and Impact Investing).