Five great short stories

In previous Quarterlies, I've outlined our valuation framework in the technology space and discussed technology business models. In this article we discuss shorting.

Investopedia explains short selling as follows: "Investment activity in which the investor borrows securities and sells them in the hope of purchasing the securities at a lower price in the future."

Whilst the short portfolio in the Platinum International Technology Fund (PITF) is small relative to the size of the long portfolio (5% to 15% weight under normal conditions), it performs the important dual role of seeking to offer downside protection and generate incremental performance.(1)

Our short strategy is relatively straightforward. We look to short weak companies run by underperforming management. Companies that typically attract our attention include those with:

• weak market positions in “winner-takes-most” markets
• declining sales and weak balance sheets
• aggressive accounting practices
• overly promotional management teams
• aggressive insider sales.

Within this pool of companies, there are five set-ups we think greatly improve our odds of success.

1. Failures (~20% of the short portfolio)

These are companies that used to be good businesses with strong market positions but where we now expect Return on Invested Capital (ROIC) to decline either due to forces outside management’s control and/or management’s inability to adapt to structural change.

One example is TV networks. Historically, US TV networks made 40%+ ROIC thanks to tremendous pricing power. Firstly, network TV was the primary form of mass entertainment and commanded large audiences. Second, TV was one of the only ways for brands to reach these large audiences. Third, the technological constraints of linear programming limited the ad space available, making prime time extremely valuable.

Today, none of these factors hold true due to social media and streaming and we expect ROIC and margins to continue declining. Advertisers can now reach bigger audiences with a higher return on ad spend due to algorithmic targeting on social media.

2. Fads (~30%)

One feature (or bug) of tech is the ‘hype cycle’. That’s where an interesting technology with narrow applications and limited market size is extrapolated by investors - with help from insiders and investment bankers - to be the “next big thing”. It then attracts an eye-watering valuation. As the growth slows and reality sets in, valuations collapse.

One example is plant-based meat in the late 2010s. Some believed plant based meat could be as big as 15% of the entire pork and meat market in the US and Europe. By 2022, it was clear consumer interest in the category was fleeting, expectations were optimistic and the industry was plagued by competition and overcapacity.

3. Broken growth stories (~20%)

These are very fast growing companies but where we have very little confidence in the underlying unit economics and the ultimate path to profitability. Those doubts can be around structural factors such as weak business models, excessive competition or low customer switching costs.

One recent example is a fast-growing electorcardiogram (ECG) devices company. Despite marketing itself as a medical device company, the business model was more akin to a diagnostic testing facility as the company is reimbursed on a per-test basis instead of selling equipment to hospitals. Once we loaded in the full costs of generating the tests we had serious doubts the business could be profitable even if they hit full US market penetration. We also had evidence of aggressive accounting practices and exaggerated clinical trial claims.

4. Capital cycle shorts (~ 25%)

In industries with low barriers to entry, some companies capture high ROIC because of temporary supply shortages. However, this typically induces a supply response - existing participants and new entrants will invest more capital in the sector to add capacity and compete for share. That drives down ROIC and potentially pushes the market into oversupply.

One recent example is the silicon carbide (SiC) supply chain. SiC wafers are made into SiC power semiconductors and when used in an electric vehicle, deliver better performance and energy efficiency relative to silicon counterparts. Three years ago, SiC wafers were in short supply. One company dominated the supply chain and commanded ~50%+ gross margins (vs ~30% for silicon wafers). We don’t think margins are sustainable because customers are investing in their own supply chains and competitors from China were able to ramp quickly and will likely add significant capacity next year.

5. Concept stocks (~5%)

These vary in shape and form but all “sell” a concept of how great the business will be with very little evidence to support their claims. One example is an AI data centre company which we shorted last year. Prior to being an AI data centre, the business went through a series of incarnations, the latest being a crypto miner during the crypto bubble. Management decided to “pivot” to being an AI data centre and put out what we politely describe as “hopeful” targets. We think their credibility is low given their lack of experience and their uncomfortably close ties to an investment bank.

• Want to invest in the Platinum International Technology Fund? You can find detailed information on the fund here.
• Take a look at Jimmy’s pieces on valuing technology stocks and business models in the technology space.

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(1) Given the sometimes contentious nature of shorting investment cases we prefer to omit specific company names from this commentary.