Following the sell-off in March amidst the COVID-19 outbreak, the S&P and numerous individual shares are currently at all-time highs. This often has investors or traders believing that it is too much too quickly. This may prompt short sellers to emerge, only to be left in the short-sellers’ graveyard as stocks grind higher for longer. Even if you are not a short seller, knowing the mindset can help avoid buying companies that are inherently flawed. Before the trade, we view shorts with a certain framework based upon the circumstances. These include structural shorts, tactical shorts and pair trades. For each of these we have a different thesis and time frame in mind in order for the trade to be successful.
Structural shorts are identified by financial irregularities, aggressive accounting, peak margins, industry-wide changes, abnormal share trading activity, management with prior dubious involvements or preferably a combination of these factors. Other factors that contribute to a structural short thesis are unsustainable debt levels, high levels of goodwill from prior acquisitions, declining like for like sales and regulatory investigations. These shorts will often take months and may even take years to play out and require patience. Ensuring that the position size is appropriate is critical.
Tactical shorts are more a short-term trade based mostly on momentum or inefficiencies in the market. Inefficiencies result from certain market participants acting in an irrational manner, such as an IPO lock-up expiring allowing for increased selling and downward pressure on the price. Momentum trades such as the current “Tech” rise we are seeing in the US are risky to short since one never knows when the euphoria will abate. Again, the position size is important. Very often the timing of the short would play a large role in the quantum of the return.
Pair trades are merely buying one company while selling another within the same sector, such as two retailers. These trades require a thorough understanding of the industry and the interrelationships between factors affecting the companies. Given that there is no net market exposure and both stocks are in the same or similar industries, pair trades carry less risk and can be done in larger sizes.
Short selling is not for everyone and requires skill, additional work as well as risk controls. In this current market, investors who short purely on valuation should be cautious. Bubbles and euphoria could last longer than some investors can remain solvent.