Should investors adopt short-selling?

Short-selling is a trading strategy, not a long term investment strategy. It relies on correctly identifying both the direction of the stock price movement and then anticipating market sentiment. The “difficulty to benefit” equation is not one we view favourably

Taxes and interest are hidden costs that further erode any potential short-selling profits


Profiting from market sentiment

Since the start of this year, Harvey Norman (HVN) and Myer (MYR) have been on the receiving end of increased short-seller activity. The stock prices of both retailers have decreased significantly since the start of the year with the imminent arrival of Amazon(AMZN) to the Australian retail market.

Source: AFR

Whilst many have found success with short-selling strategies (think the film The Big Short), we are not proponents of this style of investing for three main reasons. First, short-selling relies on predicting market sentiment. Short-selling relies on being ahead of the market and selling before the rest of the market does. Unlike how it is portraying in The Big Short, this is difficult to do consistently over the long run, as every short sale relies on a buyer who believes in the opposite – that the stock will appreciate. With the high level of public information available today, we are sceptical of those pundits purporting to be able to consistently out-predict the market. It is for this reason we do not play the short-term trading game.

Second, not only is the level of difficulty high, but the rewards are capped since stock prices can never fall below zero. We prefer to target investments that produce profits in the multiples and short-selling does not allow that to occur. From our experience, good businesses return many multiples over the long run and gains are limitless.

Third, the short-selling strategy is very rarely based on objective information. For example, the impact that Amazon will have on Harvey Norman and Myer is based on modelling and assumptions made by analysts. The market cannot accurately quantify the exact impact to Harvey Norman or Myer’s profitability. And because the trade is based on subjective information, ie the imminent arrival of Amazon, this information is available to all and not highly reliable.

Hidden costs of short-selling

It is important to highlight the impact of taxes and interest cost to the short-selling strategy which erode any profits of short-selling. Trades that occur over a period of less than one year incur a higher tax rate. Moreover, short-selling typically involves paying an interest charge during the period which the position is held, which is the cost of waiting for the stock price to fall.

The “difficulty to benefit” equation

The degree of difficulty of short-selling is high for the reasons outlined above, yet the profits are capped. Combined with hidden transactions costs that erode the potential gains significantly, short-selling seems to us a counter-intuitive strategy. One that increases the level of investing difficulty but has a cap on increased profit potential.

For us, our profitability has come from taking advantage of market sentiment that has presented itself, not predicting market sentiment. As Warren Buffett aptly describes his approach judging the “difficulty to benefit” equation: “I like to go for cinches. I like to shoot fish in a barrel. But I do it after the water has run out.”

The outcome of how the recent short-selling activity plays out may well present us with interesting opportunities should the market overreact. That is when we will join the party.

Why founder-led companies outperform

Companies where the founder still owns a large proportion of the business and is involved in managerial decisions consistently produce 4% to 10% p.a more returns than other companies.

However not all of these companies are worth investing in, but we begin our search within these companies – it gives us confidence that we are fishing in a quality pond.

The founder-ownership phenomenon

Founder-ownership, CEO-ownership, management-ownership, inside-ownership. These are all terms used to describe a similar concept – where the people in charge of a company have a vested interest to see it succeed because they own a significant portion of it. There is no shortage of research highlighting this phenomenon – some of these have been attached below. On average, the research indicates that companies with heart outperform other companies by 4% to 10% per annum.

We like this trait a lot. So much so, that we have termed it ‘heart’. It is an intangible quality that drives a business and provides a source of self-motivation for the long term. In sporting terms, heart is what motivates an athlete to put in that extra effort during off-season, with the resultant hard work giving them significant year-on-year improvement. Athlete’s with heart train with intensity and often play at a level beyond their natural physical talents. Fame or attention does not distract them. They simply love their craft and drive themselves to constant improvement. Importantly, these athletes demonstrate objective improvement over the long term. For the NBA supporters, the player that most embodies the principle of heart in the current era is Kawhi Leonard. Kawhi has sustained statistical improvement since becoming a professional 6 years ago and is renowned for his quiet excellence. A business with demonstrated sustained improvement over the long term is a great investment.

Short term management incentive structures aim to replicate this sense of ownership in management, but often fall short. Instead, they only reinforce a short term focus and incentivise management to keep one eye on their stock option vesting dates – they do not promote long term sustainable business growth.

So why don’t we just find all of these companies and invest in them?

Given that the market knows about the founder-ownership phenomenon, why then does it continue to persist? The answer is that not all companies with heart succeed. In our view, it takes more than heart, which is why we start, not finish, our search here. It would be a risky strategy to simply invest in all companies with high insider-ownership.

It is not hard to search for companies with high founder-ownership. The practical challenge is to seek out those businesses that have heart and a competitive edge. We focus our efforts on seeking out these companies with a demonstrated objective track record of performing. Then we buy them at the right price.

Sources:

Stanford Graduate School of Business research on the behavioural changes arising from inside-ownership:

https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-quick-guide-09-equity-ownership_0.pdf

Journal of Finance article analysing 22 years of data in the US markets. This research indicates outperformance of 4% to 10% per annum.

https://www.houseoffinance.se/wp-content/uploads/2016/05/executivesummaryU.pdf