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 stri