Should you be a short seller?

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In this edition of the Alpha Letter, we cover: 

  • Stocks & Options: What are the best short opportunities right now?

  • Dividend Investing: A look inside a small cap value ETF

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Stocks & Options

Is it a good idea to short sell?

There are a lot of passionate opinions on short selling. On one hand, short sellers have been villainized recently as “suits” who don’t want retail traders to make easy money on stocks like GameStop and AMC.

On the other hand, sometimes companies are grossly overvalued or actually lie to investors to artificially inflate their share prices. In those cases, short sellers do a service to the market as a whole by helping to expose falsehoods and correct over-inflated prices.

The recent vilinization of short sellers isn’t new, by the way. It’s just been amplified in the last few months. Traders and CEOs have always lamented the role of short sellers and considered them “anti-American” at times for betting against US companies.

Former Enron CEO Kenneth Lay even blamed the downfall of his company on attacks from short sellers years after the collapse. 

A common refrain from management teams is that short sellers often take a short position and then produce “hit pieces” to make the stock drop. Nikola CEO Trevor Milton did just that last year when Hindenburg Research released a report that poked several holes in Milton’s audacious claims. 

While it’s true that short sellers sometimes exaggerate or create false claims to enhance their case, we have to remember two things: One, those on the long side often do the same thing without the criticism short sellers endure. It’s perfectly fine when people looking to pump a stock make bold claims that are likely not true, but every statement by short sellers is assumed false until proven correct (or even after it’s proven correct).

Two, CEOs that vehemently attack short sellers often do have something to hide. In almost every corporate fraud case, the CEO or management team viciously attacked the “haters” who laid out negative claims about the company that ended up being true. Theranos, Enron, and WorldCom are examples.

Legitimate companies that don’t commit fraud rarely pay attention to or acknowledge negative reports about themselves.

Every claim about a stock, either positive or negative, should be evaluated objectively. Don’t fall into the trap of believing that every damaging fact about a company you hold is “fake news” or somehow a conspiracy against the company. Every single company has good and bad aspects. 

So, should you be a short seller?

Short selling is the inverse of buying a stock, but with several added risks.

While long-oriented investors benefit from time through compounding, the opposite is true for short sellers. There are added costs associated with holding a short; mostly the interest you’re required to pay to borrow someone else’s shares that you sold. 

As time goes on, your short position bleeds out if the stock doesn’t move down sharply. 

For stocks with high short interest, the borrow rate can be upwards of 20 to 30%. This means that if you short one of these stocks for an entire year, you’d need the stock to decline 30% just to break even. 

Short sellers usually look for a combination of signals to initiate a short:

  • Valuation - Company is overvalued based on its current ratios (price/earnings, price/sales, prices/assets, etc) and its future growth outlook. Lots of companies have extremely high P/E ratios, but they’re only short candidates if the market is massively overestimating future growth.

  • Management - Short sellers look for management teams that are either incompetent or more focused on enriching themselves than creating shareholder value.

  • Special situations - This could be when the market is not pricing in the correct value of an upcoming merger or bankruptcy reorganization. For example, when companies go through bankruptcy reorganization, existing shareholders usually forfeit a large equity stake to the creditors. In some cases, it can take days or weeks for the market to find the correct price after a reorg is announced. 

  • Macro outlook - A short seller may target companies, industries, or the market as a whole when they believe there is systemic risk that will cause a sell-off or crash. Market crashes are notoriously hard to predict. If it was obvious enough that a crash was incoming, then equities would sell off nearly instantly, leaving no time to build up a substantial short position. 

The above is not a comprehensive list - it just makes up a few of the most common examples.

Here are some ideas for current short targets:

One of the most popular areas of the market to short right now is electric vehicles. While Tesla has been a common short seller target based on its historically high valuation, there are plenty of other EV companies with little to no sales, questionable production capabilities, and market caps in the billions.

Take Lordstown Motors (NASDAQ: RIDE) for example. The company is now worth about $2 billion after a sharp selloff on Tuesday afternoon. 

It has no sales and barely survived a devastating short report that paints the CEO as a deceptive showman who can’t follow through on promises. 

It’s unclear whether Lordstown is actually capable of producing one functioning electric truck, let alone the hundreds of thousands the CEO claimed as “pre-orders”.

The 15% decline on Tuesday was due to KPMG issuing a going concern warning on the company, which means the auditor is questioning whether Lordstown has the financial means to remain a functioning company. 

Is $2 billion still too high of a valuation for this company? Many short sellers think so. RIDE is currently marked as “hard to borrow” due to the high demand for short positions, with Fintel noting that the average cost to borrow shares is above 40%.

Dividend Investing

We cover a lot of small and mid cap opportunities here in the newsletter. Today, I’m going to show you inside a small cap value dividend ETF. The O’Shares U.S. Small-Cap Quality Dividend ETF (OUSM) is a small cap value ETF under the umbrella of Kevin O’Leary (from Shark Tank).

It yields 1.48% and is up 16.2% this year thanks to the tailwinds in values and commodities. 

Its largest holding interests me a lot: The Interpublic Group of Companies (IPG) makes up 2.91% of the ETF. It’s an advertising company with dozens of brands that provide creative and marketing analytic consulting services to companies across offices in over 100 countries.

Valued at $13.1 billion and is yielding 3.22%. It’s also up 74% over the last year. 

Large conglomerates that own dozens of separate agencies can be tough to fully understand, but can often provide a diversified group of holdings as the different branches of the company are separate operating arms providing different services in a variety of countries across different industries. In effect, you don’t have to worry about IPG tanking just because one or two industries take a hit.

OUSM itself has slightly outperformed the DJIA benchmark over the last year, as shown above.

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