My approach to diversified shorting

The investing strategy I understand the best and feel most comfortable with is diversified shorting- taking a large number of very small positions in common shares of crappy stocks.  I mainly short stock promotions and pump and dumps, where I think I have a sizable edge over other market participants.  The performance of my strategy backtests to ~15% from May 2014 to August 2015.

The key to making this strategy work is being able to quickly find a large number of awful stocks.  This is possible because stock fraud is an industry.  Scumbags network and share knowledge with each other.  Fortunately for me, this makes them really easy to find.

Permutations of stock fraud

Most of my shorts are scams attached to real businesses.  The scams can be categorized as follows:

  1. Management employment agencies.  This is common among Canadian junior miners.  Management raises money from investors so they can pay themselves large salaries.  They may also use shareholder money to lead lavish lifestyles with corporate jets paid through the “travel and entertainment” budget.  A short becomes more attractive if insiders are actively stealing from shareholders (e.g. through related party transactions).
  2. Pump and dump.  The goal is to sell shares at inflated prices.  Insiders may hire questionable stock promoters.  The pump and dumps with reasonable borrows generally target institutional investors and are less likely to hire questionable stock promoters.  Or rather, the stock promotion that occurs is much more subtle (e.g. investment bankers promote the stock in the hopes of receiving underwriting fees in the future).
  3. Pyramid schemes.  I generally try to avoid shorting pyramid schemes.  Shorting a pyramid scheme too early can cause short sellers to lose money.  Early participants in any pyramid scheme can actually make money.  As well, a pyramid scheme that lasts a long time can cause short sellers to suffer short squeezes, protracted borrow costs, and/or a very low IRR due to the length of time it takes for a stock to collapse.  For example, the Sino Forest fraud lasted for over a decade.

The businesses can be categorized as follows:

  1. Excellent businesses.  Excellent businesses can cause short sellers to lose a lot of money even if many of the people involved go to jail (e.g. Steve Madden).  I try to avoid shorting them.
  2. Average businesses.  Sometimes shorting average businesses can lead to losses for short sellers.  For example, Robert Friedland’s Diamond Fields Resources stumbled across the Voisey’s Bay nickel deposit that was worth billions of dollars.
  3. Bad businesses.  Some businesses are bad because there is a below-par management team in a difficult industry such as restaurants, retail, etc.  Shorting bad businesses may not necessarily work out if bad management is replaced by a significantly better management team that turns the business around.  But in general, bad businesses have a tendency to stay bad.
  4. Awful businesses.  The absolute worst “businesses” are ones where management intentionally destroys shareholder capital via uneconomic mines and other money pits (e.g. underwater mining).  These are excellent shorts.
  5. Businesses that shareholders do not actually own.  This has happened with some Chinese reverse mergers, where insiders have run off with all of the assets.
  6. Companies with fraudulent accounting.  The fraud causes the company to appear better than it actually is.  These aren’t necessarily great shorts if the stocks turn into pyramid schemes.

To me, the most important factors to a short are:

  1. The people.  Stock scams occur because of the people behind the stock.
  2. The business.  I generally only short stocks with bad, awful, or no business at all.
  3. Valuation.

In practice, I research stocks based on #1 and #2.  Then, I wait for the right valuation (#3).

What diversified shorting looks like

Two of my old posts show how I arrange my short ideas.  Tier 1 consists of the stocks with the lowest quality people and/or businesses.  The tier rankings ignore valuation.

Here is my chart/spreadsheet from July 2014:

2014-july-25-short-positions-02

Here is my chart/spreadsheet from May 2014:

2014-may-20-short-positions-table-03

*Some of the stocks in the charts above ARE NOT scams.  I do short bad businesses run by honest people such as Sears, Coach, and Solarcity.  I also ran other strategies such as speculating on commodity prices (e.g. Potash) and speculating on certain solar sub-industries.

Things I don’t blog about

I can point out stocks where it is highly likely that illegal insider selling is occurring.  However, I am  not comfortable with exposing pump & dump scams and the criminals behind them.  Some scumbags will go on the offensive when others attack their livelihood and their reputation.  To them, their scams are everything.  Exposing the scam may lead to various forms of retaliation, which I don’t want to get involved in.  So, don’t expect me to give out too much information on particular scumbags or scams.

I also won’t be giving away many of the tricks that I use to find lots of scumbags quickly.  However, I have thrown out a lot of ticker symbols on this blog.  Scroll up to revisit my charts from May and July 2014.  Keep in mind that some of the stocks in my charts are not scams and aren’t run by scumbags.

Quality and quantity

In aggregate, I think that the quality of my short ideas have been fairly high despite the high number of ideas.  Some of the names on my lists were later targeted by activist shorts or the SEC:

  • FNRG – SEC
  • GSAT – Kerrisdale*
  • AVID – Copperfield*
  • BBLU, NNVC, CBMG, GLRI, PVCT – Pump Stopper
  • WBAI – Muddy Waters

*I do not necessarily agree with everything that activist shorts say.
**I am not saying that any particular stock mentioned in this blog post is a scam.
***Not all of the stocks targeted by activist shorts have fallen significantly since May/July 2014.  Avid has risen dramatically since May/July 2014.

Some of the names on my lists have fallen dramatically without any SEC intervention or attacks by activist shorts.

Quick backtesting

I put together a spreadsheet on Google Drive looking at the performance of my May 2014 chart.  The average performance of my list from May 21, 2014 to August 5, 2015 was -14.9%.  There were a number of assumptions and caveats:

  1. No borrowing costs.
  2. No dividends.
  3. I looked at stocks where I indicated that I had a position.
  4. I assume that positions were held in every stock (the chart actually indicated which positions I had on at the time).
  5. Where it says puts, I assumed that a position in the common stock was taken instead.
  6. I assumed that ACMP went up 30% (because I’m too lazy to look up its actual performance).
  7. No buy-ins.
  8. Removing the energy stocks would have reduced performance to -8.8%.

Ignoring the unrealistic assumptions and methodology problems, I believe that my picks generated outperformance versus shorting the S&P 500, which was up 11.2% in the same time period.

What I don’t do

Highly illegal and/or unethical business practices

The idea is to find businesses that are behaving unethically and/or illegally.  For example, the US healthcare industry is full of unethical and illegal practices (e.g. Medicare fraud).

However, making money on the short depends on the government or regulators taking action.  I’m not very good at predicting if and when that might happen.  As well, sometimes regulators and politicians will go after people who have behaved ethically and have not broken the law.  Politics can be too perverse and fickle for me to figure out.  This is not a strategy I am good at.

Performing extensive due diligence

Verifying a company’s assets by physically visiting them is an excellent due diligence tool, as shown by the work of Muddy Waters and Jon Carnes / AlfredLittle.com.  There were so many Chinese frauds that overstated their physical assets.  Unfortunately, I neither have the time or resources to perform extensive due diligence across all of my shorts.

Understand an industry in-depth

While I think that you can gain a significant edge on other investors by understanding a particular industry, I don’t have the time to understand every industry of every single short I have.

At the end of the day, I rely heavily on the gimmicks of understanding people and understanding the fraud industry.  My understanding of many individual stocks is actually very weak.  This is an obvious limitation of diversified shorting.

Quirks of diversified shorting in practice

Stock prices do not always follow fundamentals in the long term

Insiders often understand how bad or awful their underlying business actually is.  Because of this, many of them will try to sell the business.  Oftentimes, they actually succeed in selling the business.  A lot of private buyers get tricked into buying scams and frauds.  While I may ultimately be correct about the underlying business going to zero, I will lose money on stocks taken over at a premium.  It annoys me greatly when fundamentals ultimately don’t matter.  That’s a bitter pill to swallow.  I suppose that it’s a part of the game that I have to accept.

Many of my ideas are not actionable

In general, I try to avoid shorting a short where the borrow exceeds 10%.  This is to avoid buy-ins, short squeezes, and paying very high borrow rates for a long period of time.

As a matter of practicality, I avoid stocks with very low market caps and low share prices.  The mechanics of the borrow make it difficult to make money on those stocks (high margin requirements, inability to cover bankrupt stocks quickly, and expensive borrows).  It’s a little annoying to identify bad stocks and realize that I will not make money from them.

It’s time consuming

I am getting better at developing shortcuts for analyzing businesses.  But it does take a lot of time to sift through a lot of stocks.  I keep a spreadsheet of potential short ideas.  The spreadsheet currently has around a thousand stocks.  I have not had time to figure out countries other than the United States and Canada.

Correlation among shorts

Currently, development-stage pharma stocks are attracting a lot of money.  While there are lots of lots of opportunities in bioturds, I have to be careful about taking on too much exposure to a single sector.

However, diversifying across multiple sectors may not be enough.  I believe that there is some correlation among my shorts even though they are in different industries:

  • Many of my shorts share stock promoters (in the broad sense of what a stock promoter is).
  • Many of my shorts tend to be popular shorts that other short sellers have identified.  There is almost always competition for the borrow.  Sometimes heavily shorted stocks move together as long/short hedge funds get squeezed and their clients withdraw their money.
  • Conversely, there are some money managers who happen to own lots of stock scams.  AUM growth can create a self-reinforcing cycle where funds buy more of what they own, driving up the share prices of their stocks.  This in turn creates “high” returns, which leads to AUM growth.  Historically, there have been periods in time where “hot money” created and chased asset bubbles.

While diversification reduces the risks of short selling, I believe that there are risks that cannot be diversified away.

Recap

  1. I think diversified shorting is a great strategy.  The outperformance versus the S&P 500 vaguely approached 26% from May 2014 to August 2015.
  2. I won’t really tell you how to do it.
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