Getting ready to grow the short book

When the stars align, there is money on the table for investors in short selling – the process of selling high, then buying low. With the tide of central bank liquidity receding, David Poppenbeek from K2 Asset Management says it’s time to start judiciously growing the short book.

You need deeper analysis than usual to nail both the stock selection and the timing, as getting either wrong will eviscerate your performance. David tells us here that:

“If we can find companies that have got a profit outlook that's starting to diminish, and that today's valuation is too high relative to tomorrow's cash flow, then we think that's the start of a really good shorting opportunity”.

Watch now to hear why it’s time to grow the short book, along with some important things to consider first.

Transcript

"We think that shorting in the Australian market is going to be more prospective as we look forward. When you consider our backdrop from a profit perspective, we think that there's going to be more and more opportunities in the future.

We've been shorting stocks for the best part of 20 years, and that's the hardest part of our business, it's very, very difficult to short sell. You've got to have precise fundamental analysis that you need to do, but more importantly, you've got to get your timing right.

Over the last five or six years, as quantitative easing (QE) has been redeployed into the market, all asset classes have risen. So we had really put a self-imposed shorting ban on ourselves. While QE was underway, it wasn't sensible for us to fight the tape, it wasn't sensible for us to fight against the central banks. Eight trillion dollars of market purchases is a lot in anyone's terms.

Now that that's starting to fold out, and the quantitative easing (QT) cycle is starting, we feel that the prospects today are more advantageous to short selling.

So at the moment, we're not massive on the short side of things, but we think over the next couple of years our shorting exposure will gradually grow and grow and grow, because we think the valuations are becoming far more prospective.

If you think about what's happened, the earnings yield of the Australian equity market's gone from 10% to 6%. The average PE's over 16 times now.

Looking forward, we're not all that confident about profitability, so we're not all that confident about future cash flow. If we've got a high valuation with potential problematic projections about free cash flow, generally speaking that's the start of a good recipe for short selling.

So we think that we'll be able to isolate a few business models that are under pressure, that have got weak management and that have potentially got a competitive position that's being eroded.

We think that if we can find companies that have got a profit outlook that's starting to diminish, and that today's valuation is too high relative to tomorrow's cash flow, then, we think that's the start of a really good shorting opportunity.

Now, we short for absolute returns, we're not shorting for insurance. So we have to do a lot more fundamental work on shorts. But more importantly, we've got to get the timing right. If you get the timing wrong on a short, and the position goes against you, your position actually magnifies, and that's quite important.

So, you really have to get your timing right. Because the market can stay irrational a lot longer than you can stay solvent..."

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