This one thing terrifies a short seller… for a reason!

Every now and again someone in the financial world lets slip with a key insight on what you want to find on the stock market.

You’ll see that below.

In comes via an unlikely source – one of the least liked figures in the Aussie market.

In other words, a short seller.

You probably know the term.

These guys are the cynics and sceptics that look to profit from a share the opposite way to the rest of us.

Yep…

They’re always on the hunt for shares that are likely to go down…in a big way.

You and I want to own shares with rising sales, growing markets and expanding margins with great management.

Short sellers want to see, in some combination, declining audiences, falling profits and an incompetent executive team, preferably in a declining industry.

Short sellers want to latch on to all this before it’s obvious to the market…and built into the price.

Why are short sellers unpopular?

For the same reasons a lot of analysts don’t like slapping a ‘SELL’ on a stock.

You’ll likely get someone from that company, or a devoted shareholder, that takes great offence to the idea that their stock might be overvalued, losing market share or likely to get dumped.

Some people go as far as to say short selling should be banned.

I don’t agree.

The shorts have a great role to play in the market. These guys are incentivised to stress test companies in a way only a big financial incentive can bring.

Short sellers have exposed some of the biggest corporate scams in US history. Enron around 2000 springs to mind.

It’s happened here in Australia too.

A few years ago, a short fund targeted a popular stock on the market called Blue Sky Alternative Investments.

Here’s the truth: the short seller was vindicated. Blue Sky’s valuation and credibility collapsed, and quite rightly.

Yes – investors got burnt. Perhaps they should have done more homework.

For the rest of us, a dud was cleaned off the market, and future investors spared wasting their time and capital.

Here’s a point: short sellers don’t get it all their own way. They take huge risks.

You see…

When you buy a share, the very worst outcome is it goes broke. You can lose 100% of your investment.

That’s not good, but you know that’s the limit to your liability after that.

A short seller faces, at least in theory, unlimited risk because a share can keep rising and rising and rising.

Think of the brave and (in hindsight) foolhardy types that went short on Tesla or Afterpay over the last decade. Or Gamestop more recently…

These companies smashed the shorts because of their astonishing rise.

This is why I found the following comment from Aussie short seller John Hempton so intriguing.

The Australian Financial Review profiled him and his fund recently, and Hempton said the following, when it comes to short selling…

‘I am very scared of the fat tail.’

A ‘fat tail’ is an outcome that exists on the edge of a normal distribution curve.

It’s the kind of low probability, high impact action that results in a dramatic result.

Tesla and Afterpay were originally dismissed as overhyped, money losing, obscure industry players with unclear competitive propositions. A short seller’s dream, in other words.

It turned out they were disruptive, unstoppable forces – at least for a while – that forged new, significant niches in their sector.

Both returned their original investors many multiples of their original investments.

They smoked their early shorts as well…and why Hempton says he lives in fear of fat tail firms like those two.

A big, uncontrollable move up against one of his short positions can cost him millions.

Here at Fat Tail Investment Research, we love a ‘fat tail’ as much as it terrifies him – hence our name!

We don’t particularly care about short sellers, either way.

But we want to find the type of firms that can break through a consensus viewpoint and deliver exciting benefits for our subscribers.

One my recommendations is doing that right now…Nuix Limited [ASX:NXL].

It skyrocketed over 20% on Monday…and is now up over 200% since around this time last year when I first made the recommendation.

It, too, was a target for short sellers at one point – probably deservedly so at that.

But the wonderful thing about the share market is that a company can redeem itself, as long as it stays alive through the tough times.

Yes…Nuix had an appalling start to life as a listed company on the ASX. The price collapsed 90% at one point.

That's when I got interested.

A year ago I surveyed the wreckage…

‘What if this situation can be salvaged? What could turn it around? Is this a total turkey or is there a hidden asset here?’

Yes, was the short answer. But I didn’t know that then.

What I knew at that point was that Nuix was so hammered, so hated, and so crushed…that there was clear – and big – upside if they could turn it around over time.

A potential fat tail idea, in other words.

And Nuix have turned it around – at least so far. We’ll see how it goes over the next year. There are no guarantees here, and big risks remain.

But it’s a reminder that outsized returns – and risks – can only come from doing something outside the consensus.

If everybody thought Nuix was brilliant in 2023, there was likely little profit in buying it. That perspective would be in the price already.

Right now, you have the opportunity to act on artificial intelligence in the same way. Everyone throws around the same names that benefit…NextDC and Goodman Group, being two prime examples here.

Both of them make sense. But they’re so well-known now it’s hard to see the immediate upside.

No…to play the AI thematic you need to think about lesser known, less well priced ideas.

I can’t guarantee these ideas will be right…but if they work…the benefits could be exciting.

John Hempton is scared of fat tail ideas for a reason.

And while not all stocks will perform like Nuix…

…the opportunities can be worthwhile when they work. Nuix is proof of that in as little as a year. Who knows what it might look like in five? 

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