Outright shorts
In this strategy, we plan to make money from our view that a specific security is trading at a price which is overvalued and that the correct price is much lower. There are several reasons why a security may be trading at a price above its correct value. Colloquially, we classify these into groupings of Fads, Frauds and Fades.
The Fads are the natural hunting ground for value investors. This is where investors get so infatuated with the “story” of the company that valuations get unhinged from reality. We spend our lives looking for mispriced securities. Having developed the tools, senses, and experience to spot cheap securities, we tend to also be able to spot the expensive ones.
Cheap stocks are typically characterised by recent bad news, perceived complexity and investor disappointment, neglect, disgust or apathy – in other words low or no future expectations. Normally, when any valuation metrics are quoted in the popular media, the metrics will refer to book value or dividends. Observable management actions normally include dividend payments, share buy-backs or turnaround strategies. One or more rights issues may be required to fix problems, often only possible because an underwriter is involved, and they are normally priced at discounts to the prevailing share price.
The expensive stocks on the other hand are typically characterised by very high expectations. These normally have peak current market interest, outsized recent success, a constant flow of good news and simplicity of a very good ‘story’ told by a smooth marketing department or charismatic CEO. When any valuation metrics are mentioned in the popular media, these will reference sales, growth, or a future version of any of these. Observable management actions normally include TV and conference appearances, pictures in front of new buildings or equipment, capital raising events and talking about growth strategies. Rights issues get priced at or near the prevailing share price and are typically oversubscribed – and the capital is normally earmarked to fund further growth.
Recognising a security as being expensive is only half the job though. When a stock is ridiculously expensive already, there is no reason why it cannot become even more expensive. In fact, most of the time there is more money flowing into the idea, and the price grinds higher. There is a special section in the investors’ graveyard for those who short on valuation considerations only. The best we can do in these cases is to keep an eye on them until the steam runs out, and then to take a position when the weight of the expectations overtakes reality. For some of these, the watch period has been years.
It is probably good to mention at this time that for Fads, there is normally nothing wrong with the underlying business – they are just characterised by a price that got completely crazy for a period.
Some examples of local stocks we have successfully traded as Fads are Transaction Capital and EOH. Some international examples include Zoom and the ARK Innovation ETF.
A recent example of a successful Fad is Purple Group, which controls EasyEquities, an online trading platform aimed broadly at the individual investor community. The group has been around for almost twenty years. Over time, it has been building other financial services businesses around its core operation. The business then got a boost from the strong bull market which followed global COVID19 stimulus. As equity prices increased across the world, a legion of new South African retail investors joined the market. The EasyEquities platform was ready to welcome them with open arms. This led to some pleasing results and a lot of excitement from investors in the shares of their favourite trading platform. Many themed products were launched and regular Twitter Spaces meetings with shareholders followed. By the middle of 2021 we recognised the stock as expensive, but all we could do is keep an eye on it as it zoomed higher by another 150%. At the height of the excitement in early 2022, and roughly when we initiated our short position, the company, which we estimated to have a bankable annual profit of about R50m, sported a market cap of almost R4 bn! (No – we did not do a price-to-sales calculation!)
Chart 1: 20-year price graph of Purple Group
Source: Refinitiv Eikon. April 2023
As interest rates subsequently increased and liquidity was sucked out of markets, retail investors started to falter. Individual investors found out what professionals have known for a long time – investing is hard and brutal. Opportunistic punts in the market were replaced by mortgage repayments or even fuel in the family car. An inflationary, slow economic growth environment isn’t supportive of retail investor participation in the market, especially in a country like South Africa with a low savings rate.
At the time of writing, the share price is already 60% lower than its hype-fuelled peak but continues to trade at exceptionally high valuations. Having won the hearts of so many investors, the price has been deflating as investor emotion is replaced with reality.
This brings us to one of the idiosyncrasies of shorting – as our thesis has proven to be correct, the size of our position kept on shrinking in the fund (same number of shares, lower price), and we had to keep on adding to our short position to keep to our preferred position size – selling more shares into a falling share price. Economists call this ‘pro-cyclical’ behaviour, and academics call it momentum…. both of which are usually foreign concepts to value investors!
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