Everything you need to know about shorting

Note: You can watch, listen or read an edited transcript below. This episode was filmed on 14 April 2021.

Edited Transcript

Ally Selby: Hello, and welcome to Livewire's Buy Hold Sell. I'm Ally Selby and today we are talking about a topic which divides the market. I'll give you a hint, it's shorting. And who better to discuss this subject than two long/short managers themselves. I'm joined by Anthony Aboud from Perpetual and Sage Capital's Sean Fenton.

Sean, I'll start on you. In your opinion, what is the role of shorting in markets? And why do you think it sometimes has that bad reputation?

Sean Fenton: Well, it clearly gets a bit of a bad rap because most people are long equities, in general. And they love to see the equity market go up. So there is a bit of a false perception there that shorting pushes down share prices and it's bad for markets. 

But I think that feeds into as well, what is its role? What does it do? What benefits does it bring? What it really brings is flexibility and the potential to do different things. So it's the ability to profit from stocks underperforming the market, or falling in an absolute sense, providing protection to portfolios in certain areas. But the ability to go both long and short increases an investment manager's opportunity set to do different things.

Ally Selby: Anthony, I've read that people call short sellers almost like the market's policemen, helping to keep valuations in check. Would you agree?

Anthony Aboud: They offer price discovery. Now, obviously, they get a bad rap. A lot of these short reports which have come out - some of them much better than others - a lot of them are quite poor, to be honest. 

But for me, I don't mind that on the long side, because if someone's come out with a few angles in a short report about a stock I'm long, I sort of like that. Because they have free of charge given me some angles which I may not have thought of on the risk side. And if they're wrong, well they've pushed the share price lower and I get to buy the stock at a cheaper price. So yeah, they're a value manager's best friend at times.

Ally Selby: Is it possible you could take us through some of the benefits of shorting?

Anthony Aboud: From a portfolio management perspective, I think Sean mentioned this, markets don't always go up. And there's alpha to be generated both on the long and the short side. Yes, markets have gone up for the last 12 years, apart from short periods of time. But that might not be the case for the next 10 years.

Ally Selby: Yeah. Would you agree? Are there any other benefits you'd like to tell us about?

Sean Fenton: Yeah, definitely. People use it in different ways. The way we use it at Sage is to really focus down on our investment skills and our process. So we use it to really identify what we're good at, the company fundamentals, the earnings, where they're going to be going. 

So we want to be long companies with solid earnings profiles, good businesses that are growing, and short companies that are under pressure with falling earnings. But there's a whole lot of other things driving through the markets. And the long/short structure means that you can strip out some of those risks and really just allow your investment process to shine through.

Ally Selby: Okay. We've talked a little bit about the pros. Can you take us through some of the costs that are involved with shorting?

Sean Fenton: The costs are reasonably straightforward. So there's clearly stock borrowing costs. In Australia in particular, everything's covered in short-selling. So you've got to borrow the stock off someone else, generally a super fund, but that varies. It's generally not a huge cost. It's an annual cost of keeping that short position in place. And you basically enter into a contract with that fund. So you make them good for anything that happens. So as the stock pays a dividend, you pay that dividend back to the owner. It gets a little bit more complicated if you get some stock issues and the like. But they're the main costs.

Ally Selby: Are there any further costs you'd like to add?

Anthony Aboud: Well, the biggest cost is getting it wrong. No, I'm being serious.

Ally Selby: True. Yeah.

Anthony Aboud: That's the biggest cost to any short position. And the one thing which people don't really focus on enough is that when a short goes wrong, it becomes a bigger part of your portfolio, and harder to manage. Whereas when a long goes wrong, it's sort of becomes a smaller part of your portfolio. You can say, "Okay, I've got the timing wrong. I can look at that in a few years' time."

Ally Selby: Yeah. Well, it reminds you of what happened with GameStop over in the US.

Anthony Aboud: Absolutely. For me, you got to be very careful of obvious shorts. And that's something which we saw with GameStop. Being leveraged into an obvious short is a very dangerous game.

Ally Selby: What are the factors that you look for when assessing opportunities in shorting? Is there a filtering system that you use? Or are you actively going out looking for poorly managed companies? Or for overvalued companies? How does it actually work?

Anthony Aboud: Sort of all the above, Ally. The things we sort of identity and look for through red flags are insider selling, a CFO suddenly leaving, I call it a strange acquisition or "di-worse-ification, or whether it's just a complete change of strategy for a company and funny accounting. And then when a CEO is out there berating analysts for putting a sell recommendation on their company, that's always a red flag as well. 

So you look at all those red flags and then we go out in the field and talk to people in the industry. And then work out which companies we think are vastly overvalued, and where we've got an angle which the market is not on top of.

Ally Selby: Di-worse-ification and red flags. What about you? What do you use? Is it a different strategy?

Sean Fenton: We're pretty symmetric the way we look at things. We break the market down into broader groups of stocks, things like cyclicals and growth stocks, and resources, and yield, financials and the like. We really look for the best and worst stocks within those groupings. So as I mentioned before, we're very focused on company earnings, both long-term structural drivers, and things like company management, and structures and everything. And we have a valuation overlay. 

So for us, investment decisions are always a trade-off between the growth potential, what the company is delivering, and where it's valued. And we apply that process across the market. And our shorting is pretty symmetric. So the worst-ranked companies on that growth value trade-off are short candidates and long candidates are the best-ranked ones.

Ally Selby: Are there any tools or techniques that you would recommend individual investors use if they want to try this out?

Sean Fenton: It depends what their objectives are. If they're looking for downside protection across the market or some of their big stock holdings then put options can be an option, literally. Although the market's pretty limited in Australia to some of the larger-cap companies. 

There are also retail products out there like put warrants, which allow investors to benefit. There are contracts for difference (CFDs), similarly. Obviously, you got to be careful of leverage in that sense as well. And people clearly, I think, need to understand what they're doing, particularly with things like options that are very non-linear.

Ally Selby: Yeah. It's definitely slightly more risky. Anthony, is this something that people shouldn't be trying at home?

Anthony Aboud: Yeah. I don't think they should. I think it's too tough. If GameStop hasn't scared you off, nothing will, I guess. And with options, yes, I agree. You can limit your downside with put options, but you got to get your timing perfect. Usually, the only people who win out of options are the market makers. 

Ally Selby: Is there anything else you'd like to add?

Sean Fenton: Yeah. Obviously, if you get a short wrong, it becomes a bigger and bigger problem. If you get a long wrong, it sort of corrects itself through time a little bit. So you need to be just on top of your portfolio on a day-to-day basis.

Ally Selby: Okay. And last question, what sector are you seeing a lot of shorting opportunities in at the moment? In your mind, could this be the next big short?

Sean Fenton: Well, we do run shorts right across the market. One where we don't actually have shorts at the moment that we're thinking about, whether it's time to start putting some on, is within resources in the iron ore space. So it's been one of the strongest parts of the market. It's probably a bit of a contrarian short. 

The iron ore price has been very strong with Vale in Brazil. The dam collapse has really impacted the supply side. China's been stimulating very strong. Those things are starting to change. Vale is steadily getting its production back up. China's starting to tighten down on its financial conditions, and bringing back stimulus for steel production. 

So that could be approaching a bit of a peak. And these things go in very broad cycles. So we're looking at that as an area. Some of the big iron ore producers, maybe Fortescue, Rio, Mineral Resources, whether it's time to look at shorts on that side.

Ally Selby: That's really interesting. Anthony, your time in the hot seat. What is an area where you're seeing a lot of shorting opportunities at the moment?

Anthony Aboud: I think COVID winners. Because what's happened over the last year is there's been a lot of winners. Whether it be e-commerce, a lot of discretionary retailers etc, where the share prices are reflecting that the good times for the COVID winners are going to last forever.

Anthony Aboud: We generally think that people are going to shift their consumption away from buying stuff to buying experiences over time. And so as that happens, you might see some negative like for likes in some of the winners like discretionary retail.

Ally Selby: Well, that's all we have time for today. I hope you enjoyed this episode as much as I did. Remember to subscribe to our YouTube channel so you never miss an update.

What sectors do you think are overvalued? 

Sean points to iron ore miners, while Anthony thinks the COVID-winners are currently overvalued and present good shorting opportunities for investors. But we would love to know what you think! Let us know what sectors and companies you believe are overvalued in the comments section below. 

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