Saturday, 7 November 2015

Using Short Interest Data to Make Better Investment Decisions

Shorting individual stocks is a hard game. Investors who do so face high costs to borrow the stock, bear the risk of unlimited losses, and are rarely popular amongst the mainly long-only investment community. To be a successful shorter you generally have to be an excellent analyst, a good trader and most importantly be right.

In the UK since 1st November 2012 there have been disclosure requirements in place that require anyone short more than 0.5% of the outstanding share capital of a company to declare this.

The Financial Conduct Authority provides a daily spreadsheet with these details. Originally I used to download and manipulate the data in Excel but very helpfully Castellain Capital has provided a website that does it for you:

Given that short funds tend to be ‘smart money’ how much notice should you take of a large short interest in a stock?

Firstly it is important to check for corporate actions – there are many funds that are involved with takeover arbitrage. This strategy involves assessing the likelihood of a takeover going ahead and judging if the market has mispriced this. A typical position to take account of a mispricing is to go long the acquired company and short the acquirer. So if the company you are interested in has announced a takeover of another and this hasn’t been fully priced into the market expect short positions to increase.

The second thing to look for is the presence of convertible bonds issued by the company. These are often used for a volatility arbitrage strategy called delta hedging. This strategy requires the trader to be short the equity of the convertible. Hence if a stock has a large convertible bond you can expect a large short position to be declared.

If you have either of these cases a declared short position is nothing to be concerned about since they are related to strategies that don’t require the equity to fall in value to profit.

Also seeing ‘Quant funds’ declaring a short is not usually that concerning since they are not doing research into specific companies but buying and selling a very wide portfolio of stocks based on certain factors (value, momentum) that have historically delivered over/under-performance. By buying a stock with a quant-based short you are of course buying something that is either in a medium term downtrend or looks expensive on typical value metrics like P/E. This should act as a warning sign but if you are a value investor buying a bombed out stock and can explain why it may appear expensive on typical value metrics but is indeed undervalued this shouldn’t deter you. A good example here would be an oil explorer that has fallen in response to the drop in oil price. It may have no earnings and a high price-to-book but still hold a very valuable oil asset. Of course you have to be sure that there is a clear route to monetisation of that asset through sale or development that remains viable in a low oil price environment. If you have done a solid valuation based on conservative assumptions then a quant fund declared short shouldn’t put you off since it is unlikely that they have done a similar analysis.

After you’ve ruled out corporate actions and convertible bonds then the presence of discretionary stock picking funds that are short should be a big red flag. Given the inherent risks of short-selling those funds also tend to share research and be activist – through publishing reports or going on financial TV to explain their negative views. Therefore if you see a large increase in a declared short position it should act as a very strong signal to be wary – negative news is likely to be on the way.

Given the breadth of companies available to an investor to allocate their capital to, one may simply want to avoid these companies. However, although I take increasing discretionary short interest very seriously, short sellers still suffer from the same biases as the rest of us. It is my experience (although I cannot prove this with objective data) that short sellers sometimes get it wrong on individual companies when they engage in sector or ‘story’ shorts. This is where they take a sector view like ‘oil is going down’ or ‘The UK High Street is Dead.’ These investment theories may be well founded but their implementation will never be perfect when expressed through individual stocks. Therefore where you see high short interest around a particular sector like UK Supermarkets but your analysis shows that one of the companies in that sector is significantly undervalued due to the unique nature of the business then that can be an opportunity. If your investment thesis proves to be correct then you will get very handsome returns since you have short funds who will become large buyers of the stock as the company releases positive trading results and the price rises.

An example of this at the moment I believe is Home Retail the owner of Argos & Homebase which (as of 6th November 2015) has an 8.9% declared short interest according to:

Why do I think the short funds are wrong?

Firstly they have got it wrong in the past. Looking at the history of Home Retail’s short interest, it peaked at 15% in Jan 13 when the share price was c£1.20 and dropped to its lowest point around mid 2014 when the share price was £2+. The nature of these businesses has not changed significantly since this period and the progress to an increasing digital store portfolio is significantly more advanced today than it was in 2014.

Why might they be short?

This is where the story comes in. The UK high street has serious structural problems. Retail is increasingly moving online. The historic high cost rents of the high street are a drag on profits compared to an internet retailer like Amazon.

What might they have the missed?

  •  Argos is the UK’s second biggest internet retailer behind Amazon ( I doubt many hedge fund managers shop at Argos but plenty of people do.
  •  Like most retailers they are highly cash generative and run negative working capital so funding growth is easy. They are currently investing in digital stores and same-day delivery infrastructure. Very few companies will have the range and infrastructure to be able to offer same day service. Amazon are just starting this to so if this is a unique value proposition for people then this may end up like a duopoly with only Amazon & Argos with the scale, range and delivery infrastructure to offer this. They have cash on their balance sheet t
  • They own their own credit book – that is money they have lent to customers to buy from them. This isn’t the highest quality of credit, they have taken provisions against bad debt of 10.1% of the loan book, however net of provisions this is still worth £550m. This is an asset that could be sold off or securitised. This may not be the best thing for the business as a whole since they use this for promotional activity (interest free credit etc.) however it remains an asset that could be sold to fund investment or simply return cash to shareholders.
This of course is not an exhaustive analysis, there are some negatives like a pension deficit and some onerous rent provisions and given the level of short interest one would want to do a thorough analysis. However given the £0.9b market cap and netting off the £550m financial services loan book you are not paying much for the underlying business – and that in my opinion makes it worthy of further investigation.

Tuesday, 3 November 2015

Should you average down or up?

One of the most contentious topics in investing seems to be the issue of whether you should average up or average down. That is whether you should consistently add to a winning position or add to a losing position. Great investors hold strong and often contradictory stances on this topic and their views are widely quoted. E.g.

We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down. Walter Schloss

‘Always sell what shows you a loss and keep what shows you a profit’. Livermore

...a price drop [is] as an opportunity to load up on bargains from amongst your worst performers…a price drop in a good stock is only a tragedy if you sell at that price and never buy more. Peter Lynch

Don’t garden by digging up the flowers and watering the weeds. Warren Buffet

One of the mistakes investors can make when reading these quotes is to read these as strict rules. They often miss the caveats contained within them. For Schloss averaging down has to be in something still ‘undervalued.’ Lynch says a price drop in ‘a good stock’ is an opportunity not a price drop per se. Knowing Buffett’s strong focus on the performance of a business not the market price I’m sure his ‘flowers’ are well performing businesses with good economics and his ‘weeds’ are badly performing businesses. I doubt any of these investors are recommending taking action purely on price action alone yet often we interpret them as such.

The other issue with saying one is ‘averaging down’ or ‘averaging up’ is it suggests that your current average buy price matters. It does not. To the fully rational investor a historic trade price is completely irrelevant. A rational investors asks themselves ‘given all current information do I have the right position size in relation to the risks and potential return?’ not ‘should I average up or average down?’ (See my blog post on portfolio optimisation)

Rules like ‘never average down on a losing position’ can be used to try to overcome behavioural biases like loss aversion but they should be recognised for what they are – an attempt to overcome one’s personal bias – not a general investing rule that everyone should follow. Rules can be very useful way of addressing behavioural biases (see: my blog post on portfolio rules) But for a rule to be relevant then it must address a bias that has led to past under-performance. If you have a tendency not to recognise when the fundamental investment case has significantly deteriorated and have a history of adding to positions that never bounce back then set a ‘don’t average down’ rule. If you have a habit of being overconfident and over-sizing your winning positions then set a ‘no averaging up’ rule.

For everyone else simply optimise your portfolio regularly based on the latest information available and forget what the average buy prices of your portfolio constituents are.