THE THREE PROFIT CENTRES OF SHORT SELLING

Or why I stopped short selling - Part II

23
9

Short selling is not appropriate for 99% of investors, and over the long term is not a winning strategy. However, for fund managers looking to outperform an index, short selling can help to create alpha, and successful short selling helps to raise your profile and raise capital - two of the hardest things to do in the fund management business.

Short selling is not really taught at universities or MBA programs. Almost all of finance is dedicated to long-term long investing. Short selling community has an above average number of “bad players” who use a technique call short and distort - which is to be short a company, and then launch a negative publicity campaign against that company. This has created a negative image around short selling, and I believe led to it being under researched. In the many years I have spent doing and studying short selling, I have found there are three profit centres for short selling. Capital gains, carry, and currency.

Capital gains is the easiest to understand. You find a long-term investor in a company that you believe is overvalued - you borrow their shares for a fee, sell them in the market. If the share price drops, you buy them back and return the shares to the investor and keep the difference - which will hopefully be a capital gain. This sounds much easier than it is in practice. “Obvious shorts” have a very nasty habit of rallying until all short interest has been eradicated. Before Tesla was recognised as the leading electric vehicle and self-driving software company in the world, it was also one of the most shorted companies in the S&P 500. For many years 20% of its float was out on loan for shorting. Short selling losses on Tesla would be easily in excess of US 100bn and probably a multiple of that. Tesla shares are down 50% this year, just when short interest is at its lowest. This is very typical of a heavily shorted stock. In my experience popular shorts never make money, as there will inevitably be a short squeeze (see Gamestop, AMC etc). As a trading rule, if the borrow on a short is over 2%, do not short that stock. For reference, and easily stock to borrow should only cost 20 to 30bps.

The example of shorting Tesla was replicated in the performance of unprofitable technology companies. They rallied significantly during the Covid bubble, before crashing back to earth. Consensus shorts tend to destroy capital. They destroy short sellers on the way up, and they short retail and momentum investors on the way down. The only beneficiaries are insiders who remembered to sell at the top.

When I was younger this made me think you should only short sell when you start to see short interest rise from low levels. But how low is low enough? The NYSE used to report short interest at percentage of total shares, but this was stopped in 2012, but from 2007 you could get total short interest value of US market. I have mashed them together so you can get a feel for short interest trends. As you can see, shorting in 1998, when it began to rise, was two years too early, and the rise in short interest in 2015, was 6 years too early.

The second profit centre of short selling is carry. This is where the vast majority of profits on short selling are made. What is carry? When you short sell a stock, you receive cash proceeds. Typically, the broker you have used for the short sale will hold on to the cash as collateral (not always), but will put the money in market to accrue interest. If you can earn more interest on cash that you lose on short selling, you will generate carry. The heyday of short selling was from 2000 through to 2008, when the S&P dividend yield 2% on average, and the average carry was 4%. From 2008 onwards, the S&P dividend yield has again fallen back to 2%, while the carry proceeds has been zero. Short-biased funds over this period were basically liquidated.

The final profit centre for short selling is currency, and it is/was the area that I specialised in. Developing currency as a profit centre for short selling grew out an experience during the GFC. At the time I was running an emerging market fund, and I became increasingly convinced that the Baltic states were going to have to devalue. The banks with the biggest exposure to the Baltics were Swedish banks, so I shorted Swedbank. This was an epic short, but in the middle of 2008, I started to notice that my USD profits from my Swedbank position was not growing even as Swedbank continued to fall. When I asked the CFO about this, he told me that my short profits were being generated in Swedish Kroner, which was now falling as fast as Swedbank. This is a technical issue, which I can discuss further if there is interest, but nevertheless it made me think about how to use currency to maximise profits from shorting. In the simplest terms, when you short a company, you want to short it a currency that will be hard currency - that is a currency that will not fall as your short thesis plays out.

This changed my mind set for shorting from thinking about companies first, to thinking about currencies first. For example, if you wanted to short iron ore miners, you wanted to short in US dollars, and not in currencies that were going to move with the iron ore price, like Brazilian Real or Australian Dollar. Shorting Brazilian Iron Ore miner Vale - was far more profitable in its US line, than its Brazilian line. The US dollar line fell 94% and is still 60% below in 2011 peak. The Brazilian line fell 82% (the difference in nominal terms is still 50%).

The logical extension of this was shorting Japanese stocks when the Yen traded as safe haven currency. The question for shorting then was when did a country devalue? The answer I came up with what that most countries chose to devalue, as it exported their problems to their trade partners. The BIS provided a pretty good measure of when a currency was expensive or not. Looking at the experience of Japan and Korea (countries most like China), it seemed to me that when an exchange rate got to 130 level on the BIS measure, you should expect devaluation policies to follow, as Japan has had since 1994, and Korea did in both 1997 and 2008.

On this basis, I have been expecting China to devalue in some way since 2014 when it first touched 130 on the BIS measure, but this has been wrong. I have spent the last year trying to work out why this was wrong, and has led me to my pro-labour versus pro-capital theories.

Without currency devaluations, and very low interest rates, the two reliable profit centres of short selling were broken in 2021, which is why I stopped short selling. But with short term rates now above dividend yields, using carry as a profit centre for short selling looks viable again.