We strive to own a portfolio of leading companies that will grow in value the more we let them alone—even as we, of course, watch our businesses closely. To hedge an ever-variable part of our long market exposure, we also want to manage an active basket of shorts—stocks we borrow and immediately sell with hopes of profiting by buying them back later at lower prices. When the market falls sharply, a basket of short positions can compensate for a sizable portion of the decline, commensurate with the allocation afforded the basket.
But selling short is not easy, requires steady attention, has unique risks, and is an active strategy. Ideally, any short seller already has many years of learning experience selling short, and in various market conditions, because that could help them to be a better short seller today. I’ve been selectively selling short stocks since 1996. Most of our short sales here at 1623 Capital will be shorter term in nature, with the positions staying open weeks or months, rarely years, and steadily refreshed with new shorts as opportunities arise.
When it comes to business attributes, it stands to reason that our shorts should largely be mirror opposites of our longs. Let’s look:
- Diminishing relevance. Many of our shorts will be steadily slipping in business stature; some will already be deep in a valley of darkness, with little chance of seeing the sun again. We want to short businesses that are being abandoned by customers as the world changes—businesses that lack strong relevance or importance today. Barring that, we want to short inferior businesses operating in commoditized niches, lacking pricing power, thin on expansion opportunities, and trying to make weak business models or struggling products work.
- Much that needs to go right. Just as we want it to be as easy as possible for our long investments to keep growing, we want the odds stacked high against our shorts’ prospects for growing at all. Business is typically already going poorly at our shorts, and we want a great deal of various factors that need to go right if the business is going to improve at all. We don’t want to short companies that can, with one or two fixes, change their destiny for the better. We want to short companies that are likely to continue to suffer even if management is able to improve a few factors.
- Piecemeal management. Rather than the aligned, proven management teams that we see at many winning companies, lagging companies are often run by ad-hoc management teams brought together as a Hail Mary; they may even have one foot out the door. In fact, we like to see that recent managers have left. We like to see managers who aren’t financially well aligned with the company’s success, and managers who lack clarity in their business plans.
- Financial headwinds. Crushing debt loads at high interest rates can have the effect of keeping a struggling company’s head close to underwater, if not submerged. That makes it difficult for management to breathe easy enough to stage a recovery. Declining sales, falling profit margins, increasing costs—all can combine to make a recovery especially difficult, and we seek these situations out. Add financial headwinds to the mix, and we may have an ideal short candidate.
Other tangibles and intangibles also help us recognize a company we want to add to our short basket. We can touch on more factors down the road—along with the types of situations we do not want to short!
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The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.
A short sale involves a theoretically unlimited risk of an increase in the market price of the security sold short, increasing the cost of buying those securities to cover the short position, and thus a possible unlimited loss.