Tuesday, March 24, 2015

The limits of activist short selling

Last week, The New Yorker published an article by James Surowiecki called In Praise of Short Sellers. The title is a bit misleading, since the article focuses on activist short sellers rather than short sellers in general. The tone is laudatory: while short selling is often criticized, activist shorts are actually a good thing because they counter "Wall Street’s inherent bullish bias," play "a vital role in uncovering malfeasance," and "contribute to the diversity of opinion that healthy markets require."

I have a more skeptical opinion of activist shorting. I don't think it's inherently bad, but neither do I think one can generalize about it the way Surowiecki does. Activist short sellers have been financially successful and have uncovered numerous frauds in the past few years, but there's no guarantee they will be successful or beneficial in the future.

Activist shorting, as it's practiced today, has a few potential flaws:

1. There's an inherent conflict of interest. Activist shorts make money when the stocks they target go down, and this gives them an incentive to exaggerate their targets' problems. Having hyperbolic bearish opinions in addition to hyperbolic bullish opinions doesn't make the market more efficient. It just means there's twice as much misinformation.

2. Over the past few years, activist short sellers have had a high batting average and have exposed dozens of Chinese reverse-merger frauds. Their success has trained investors to assume that allegations of fraud are correct until they're disproved. This allows Batesian mimics to free ride off the success of past activists by making specious accusations of fraud.

3. The Chinese reverse-merger companies were unique in how completely, pervasively fraudulent they were. Exposing them brought a lot of activist shorts to prominence and increased the amount of money that activist shorts have to invest, but now that most of the Chinese frauds have been busted, there's a much larger pool of money/talent chasing fewer frauds.

4. Many investors piggyback on activist short sellers, raising the cost to borrow shares of activist targets.


Examples of bad activist shorting

• Amtrust
John Hempton argues that Geoinvesting's report on Amtrust is full of serious errors.

 Blucora
A Gotham City Research report accused Blucora of distributing malware and facilitating Internet searches for child pornography. Neither accusation was true, but Blucora stock fell sharply the day after Gotham released its report.

 Globalstar
Kerrisdale Capital called Globalstar "The Most Egregious $4 Billion Stock Promotion Since Sino-Forest." Sino-Forest was an arrant fraud that stole hundreds of millions of dollars from investors. By contrast, Globalstar's controlling investor has poured money into the company. Globalstar may have a flawed business plan, but it has nothing in common with Sino-Forest.

 Lennar
Barry Minkow's Fraud Discovery Institute accused Lennar of cheating its joint-venture partners and running a Ponzi scheme. The accusations were false and were part of an effort to extort money from the company. Minkow later pleaded guilty to conspiracy to commit securities fraud and went to prison.

 Lumber Liquidators
At Whitney Tilson's suggestion, 60 Minutes investigated Lumber Liquidators. The television show later claimed that some of the company's products have harmful, illegal levels of formaldehyde. Since then, this claim has effectively been refuted-- see articles from Citron Research, "Max Vision," and The Motley Fool. I don't think Tilson intended to smear Lumber Liquidators when he approached 60 Minutes, but after the show aired and the company responded, he dug in and repeated misleading statements about its products.

Notably, Geoinvesting, Gotham City, and Kerrisdale have done good research on other companies. Geoinvesting and Kerrisdale have exposed Chinese frauds; Gotham City's research brought down a Spanish fraud called Let's Gowex. Being right on one company doesn't guarantee that an activist short will do quality work on others.


"Only shady companies attack shorts"

Surowiecki ends his article by repeating the popular belief that companies don't criticize short sellers unless they have something to hide:

Of course, short sellers are often wrong, and that may yet prove to be the case with Lumber Liquidators. But the fact that the company’s response to the charges was to attack short sellers should give investors pause. In a 2004 study, Owen Lamont, a business-school professor, looked at more than two hundred and fifty companies that had gone after short sellers—filing lawsuits, calling for S.E.C. investigations, and so on. Their long-term performance was dismal: over three years, their average stock-market return was negative forty-two per cent. That suggests that, if you react to bad news by shooting the messenger, it may be because you know the message is true.

This is less meaningful than it sounds.

Nearly all of the companies in Lamont's study were speculative companies with questionable prospects. Many were outright frauds. It wasn't the act of retaliating against short sellers that made their stocks go down, but the fact that their retaliation was symptomatic of much deeper problems. Lumber Liquidators is a real business with a history of profits. Apart from criticizing short sellers, it has nothing in common with Lamont's losers.

And Lumber Liquidators actually has a good reason to criticize the shorts. As a retailer, it depends on its customers' trust to stay in business. The claims that 60 Minutes made about the company didn't just temporarily hurt its stock price, it arguably caused lasting damage to the business itself.


Conclusion

Activist shorts aren't necessarily wrong, but they aren't necessarily right either. Investors should judge activist short claims individually and avoid generalizations about how short sellers are doing a public service or only guilty companies attack their critics.

Friday, March 20, 2015

Kill your investing gurus: billionaire hedge-fund managers

Many of today's most successful hedge-fund managers are open about their investments and investing strategies. They write detailed investor letters, they give television interviews, et cetera. Additionally, large funds are required to make 13F-HR filings with the SEC that list the American stocks they own. Understandably, these letters, interviews, and 13Fs attract a lot of attention. People read them hoping to find good stock picks or learn new ideas about investing.

This post argues that following top hedge-fund managers is mostly a waste of time. Specifically, it argues that:

• Most elite hedge-fund managers aren't singular geniuses. They're above-average investors who have benefited from being in the right environment for their investing strategy.
• For every fund manager who's become really rich, there are many others who have used the same strategy but are much less rich. Skill isn't necessarily what separates the richest from the rest.
• Some elite fund managers owe their reputations to shrewd marketing rather than shrewd investing. Some of them have gotten rich by charging high fees for mediocre performance.
• Over the past 15-20 years, the hedge-fund industry has grown exponentially. This constant influx of new money into hedge funds has artificially raised their aggregate returns.


Environment versus skill

A couple weeks ago, I wrote a post about Dan Loeb's early career. It described the kinds of investments he made in the late 1990s and early 2000s, before he and his fund became well-known. One thing the post didn't mention is that Loeb and David Einhorn had numerous overlapping investments during that period.

Loeb wrote about many of his investments on public message boards, and the first chapter of Einhorn's book Fooling Some of the People All of the Time describes his experiences during the 1990s. Between their writing and their 13Fs, we have a good sense of how they invested, and it was often the same: They each invested in Summit Insurance Holdings and Consolidated Freightways. They each lost money on Reliance Acceptance. They each made Agribrands their largest investment in 1998. They each shorted Computer Learning Centers, Conseco, and Sirrom. They each acquired more than 5% of Stage Stores in 2001 when it emerged from bankruptcy.

Einhorn's 13F filing from November 12, 1999 shows 22 investments worth at least $1 million. 10 of those 22 were stocks that Loeb owned at the time or had owned previously. The overlap was even greater for their favorite stocks: Einhorn's largest and second-largest investments were Loeb's largest and third-largest, respectively, at the time.

This overlap in individual stocks reflected a shared philosophy: both Loeb and Einhorn specialized in making the kinds of niche investments that Joel Greenblatt described in You Can Be a Stock Market Genius: spinoffs, demutualizations, companies emerging from bankruptcy, etc. Loeb recommended Greenblatt's book in numerous message-board posts. Einhorn has also recommended it.

Today Loeb and Einhorn own few of the same stocks, but their careers have nonetheless followed the same trajectory. They've experienced similar growth in assets under management, they've both set up reinsurance companies, and their funds have both underperformed the S&P 500 in recent years.

Since these guys are billionaires, it's tempting to assume that they must be uniquely talented. But the similarity between their investments and investing strategy-- a similarity that was particularly strong in the late '90s, when they earned their highest returns-- suggests otherwise.

That doesn't mean they aren't skilled investors: they were both savvy enough to realize that special situations were a great, undiscovered opportunity. But it was this opportunity, rather that unique skill on their part, that let them beat the market so handily.


The richest investors aren't necessarily the best

Not every talented investor cares about making as much money as possible. Some are willing to grind away in order to become multi-billionaires, but others are content to retire with $25 million and enjoy the good life. For every hedge-fund billionaire, there's probably an equally talented investor who cared less about money than spending time with his family, traveling the world, or something else. Warren Buffett and Ben Graham illustrate this contrast:

What made Graham a lot of money was realizing that convertible bonds and preferred stocks carried a valuable option that was often undervalued, and so he would buy the convertible security and short common against it.  Strategies like this, plus activist investing, where he uncovered information advantages on undervalued stocks allowed him to become wealthy.

And that was enough for him.  Unlike his more focused protege, Warren Buffett, once the game got too tough, and a pleasant retirement was attractive, he trotted into the sunset...

Joel Greenblatt pioneered the style of investing that made Einhorn and Loeb famous, but his hedge fund peaked at $500 million in assets, whereas they each manage a fund worth more than $10 billion. Presumably his personal wealth is also much less.

Sometimes the richest investors get that way by being aggressive rather than thoughtful. I've written before about KKR and Wesray, which were two of the most prominent private-equity firms in the 1980s. Wesray made fewer acquisitions in the late '80s as valuations rose, while KKR was always eager to do bigger deals at higher valuations. Wesray's leveraged buyouts performed better than KKR's buyouts, but KKR's principals are richer because they used leverage more aggressively during a long period of rising asset prices and falling interest rates.


Getting rich off fees and marketing

The backward-looking attitude of hedge-fund investors has helped make a lot of fund managers rich. Loeb and Einhorn have earned large performance fees in the past few years as their funds have underperformed the S&P 500. Investors have been willing to pay them these fees because of the historical returns that they earned on much smaller amounts of money in a much less competitive environment.

Many top fund managers also owe their success to shrewd marketing, specifically their ability to be promotional without seeming promotional. An Economist profile of Seth Klarman illustrates this, claiming that he stays out of the spotlight while shining one on him:

Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.

Klarman also made a shrewd move when he let Margin of Safety go out of print. Used copies now fetch $2000 on Internet auction sites, and this has contributed to perception that he's a value-investing legend. In reality, both the book and his returns are good but not phenomenal.

Einhorn's public crusade against Allied Capital lets him portray himself as a thoughtful, methodical investor who exemplifies integrity.

Howard Marks has his widely-circulated memos, which state what every sophisticated investor already knows but state it so eloquently that people feel like they're learning something new. As expositions on investing, the memos are mundane. As marketing aids, they're brilliant.


The hedge-fund industry is a Ponzi analogue

I believe that hedge funds are an example of what Robert Shiller calls "naturally occurring Ponzi processes." A Ponzi process happens when an investment's performance depends on continuous inflows, without which its price will fall. Initially, inflows cause an investment to appreciate. This encourages more inflows, which cause further appreciation, and so on.

In 1998, hedge funds had $140 billion of assets under management, and a large chunk of that was in two macro funds. Today the industry has more than $3 trillion in AUM.

As hedge funds have prospered and received more money, they've poured it into many of the same investments that originally made them successful. In the aggregate, the industry has invested increasing amounts of money into spinoffs, distressed debt, industry-consolidation plays, etc.

In his Inside the House of Money interview, Scott Bessent describes what happens when more and more money is thrown at the same investments:

[I was] short a Janus stock during the Internet bubble. There was this fund called the Janus 20 and the only reason the stocks went up was because of asset inflows. The mutual fund was taking in $50 million a day and they just kept jamming it into those 20 stocks.

The hedge-fund industry's experience over the past fifteen years has been Janus 20 writ large. While top hedge funds are more sophisticated than a bubble-era mutual fund, the basic dynamic is the same.

Some fund managers like Julian Robertson and George Soros have invested for decades and made money in numerous market environments. It's safe to say that their returns are skill rather than luck. The fund managers who have risen to prominence in the past 15 years have only experienced a single market environment, one that has been extremely favorable for them. If they had to invest with stable or shrinking AUM, their alpha would probably disappear.

Monday, March 9, 2015

Historical case study: Japanese banks in the 1990s

Julian Robertson is one of the investors whom John Train profiled in Money Masters of Our Time. Robertson's hedge fund, Tiger Management, was short Japanese banks during the 1990s, and the appendix of Money Masters includes an internal memorandum that a Tiger analyst wrote describing the firm's rationale for shorting them.


Japanese vs. American banks

The analyst, Tim Schilt, wrote in 1995 that "Japanese banks have the largest market capitalizations and lowest measures of profitability of any banks in the world" and illustrated this by comparing Citicorp to Mitsubishi, which he called "Japan's best bank."

While the two banks had approximately the same equity, Mitsubishi's balance sheet was 87% larger. The quality of its assets didn't match their quantity, however: Citicorp's return on assets was 4.2%, while the "best bank" managed only a 1.1% RoA. In light of Citicorp’s better returns, one might expect it to have garnered a higher valuation, but the opposite was true: Citi traded at 5x pre-tax earnings versus 27x for Mitsubishi.

While stark, this disparity wasn’t new. Grant's Interest Rate Observer described a similar contrast between Japanese and American banks in 1987:

U.S. Trust Co. is the Rolex watch of the American trust business. Last year it earned 18.3 percent on its equity. Yasude Trust & Banking, a kind of Japanese Timex, earned only 13.5 percent on its equity.

However, while U.S. Trust fetches only 10 times last year's earnings on the New York Stock Exchange, Yasuda commands 133 times earnings on the Tokyo and Osaka exchanges...

[Yasuda] has accumulated a book of Third World loans equivalent to 100 percent of its estimated equity, and it owns a book of "poor or non-performing" loans, both domestic and foreign, equivalent to four times its estimated equity.


Loan losses

Officially, Japan's 21 largest banks had non-performing loans equal to 3.6% of total loans. But as Schilt wrote, the actual level of losses was much higher:

Excluded from the NPL category are loans to the housing loan companies where at least Y5 trillion is in serious arrears. Also excluded are the restructrued loans, where companies are being supported by reduced interest rate and principal payment terms.

Finally, loans that have been sold to the Co-operative Credit Purchasing Company (CCPC), the major avenue by which banks are taking bad-debt-related charge-offs, are no longer included in NPL's, a questionable practice, in my opinion. Since its inception in March of 1993 through July of this year, the banks have sold Y8.8 trillion face amount in loans to the CCPC for Y3.9 trillion, a 56% aggregate charge-off level. The banks provide the financing for the CCPC to purchase the loans from them, and then, believe it or not, start accruing interest and paying taxes on this interest as if the loans are current at the contractual rate.

The reasons why I question the validity of removing loans sold to the CCPC from the NPL category are twofold. Firstly, the ultimate charge-off to the bank is determined when the loan (in virtually all cases a real estate property) is actually sold by the CCPC, and secondly, the CCPC has disposed of only Y204 billion (5.2%) of the properties to date, a telling reflection that bid and asked prices are still way apart...

While reported NPL's declined by Y1 trillion last year and the loan loss reserve increased from Y4.5 trillion to Y5.5 trillion, total charge-off and reserving costs of Y4.9 trillion indicate that loans are still going bad at an alarming rate. [One Japanese bank analyst] estimates that the twenty-one major banks have Y45 trillion in NPL's, a staggering 12.9% of their loan book. My estimate of Y30.5 trillion (8.8% of loans) is more toward the lower end. Either figure is huge when measured against total shareholders' equity of Y21.4 trillion, loan loss reserves of Y5.5 trillion, and unrealized securities gains of Y9.0 trillion, a total of Y35.9 trillion.

The unrealized securities gains were less of a cushion against losses than one might have expected, since they were pro-cyclical: Japanese stock prices fell during the 1990s as bad loans proliferated.

While the CCPC let Japanese banks understate their loan losses, some banks used even more questionable methods to hide bad loans:

In Japan, companies were only required to reveal what was happening in their subsidiaries if they owned a significant stake in them... As the problems mounted up, LTCB started to take advantage of this principle. In December 1991, the bankers created a company called 'NR,' which was designed to act as a warehouse for some of the nonperforming loans... the bank started to 'sell' its assets to NR at book value...

This did not, of course, really improve the problem in the long term. Companies like NR were only able to purchase these risky loans because LTCB itself lent it the cash. Thus LTCB had simply replaced one set of bad loans with another. However, NR was such a tiny, obscure group that nobody outside the bank noticed the scheme. Better still, the bank was allowed to classify its loans to NR as 'healthy,' since NR was considered to have the support of LTCB.


Normalized earnings

Schilt estimated that Japanese banks would need to spend at least six years repairing their balance sheets before earnings normalized, which was twice as much time as most bank analysts expected.

But even assuming that losses normalized at lower levels, the banks weren't particularly cheap. With annual losses equal to .20% of risk assets, the 21 largest banks would trade between 27x and 140x earnings. At a .40% rate, several banks would be unprofitable and the rest would trade between 37x and 261x earnings.

Schilt argued that an emphasis on real-estate loans to the exclusion of higher-interest consumer loans kept Japanese banks' profit margins and returns lower than those of foreign banks.


Bank stocks defy gravity... for a while

From 1990-97, Japanese bank stocks significantly outperformed the Japanese stock market. Accordingly, Schilt wrote that "The Japanese banks have been a frustrating investment experience for Tiger."

Below is a chart comparing Mitsubishi Bank (gold line) with Japan's TOPIX index (black line) from 1990-2002:


By 1994, Mitsubishi had outperformed the broad Japanese market by 50% and exceeded its price at the end of 1989, when the Japanese market peaked.

It wasn't until 1997, two years after Schilt's memorandum, that Japanese bank stocks collapsed. Their collapse coincided with several things:

• A tax hike in April 1997 that led to a recession.

• The failure of three Japanese financial companies in November 1997: the fourth- and seventh-largest brokers and the tenth-largest bank. Their collapse led to fears that Japan's Ministry of Finance had withdrawn its longstanding support for loss-plagued financial institutions.

• The Asian Financial Crisis, which generated a new round of loan losses for Japanese banks.

• The peak of Japan's working-age population and the peak of Japan's CPI.

I'm not sure how much the declines in Japan's workforce and price level contributed to the banks' woes. Each experienced a modest initial decline that didn't accelerate until 2000.

On the eve of the Asian Financial Crisis, Japanese banks accounted for one-third of the international loans made to Indonesia, Malaysia, South Korea, and Thailand. One academic paper argues that Japanese banks were instigators as well as casualties of the Crisis:

Japanese banks were the critical actors who triggered the devaluation inadvertently when they reduced their exposure to Asia due to the need to avoid losses and to protect their capital base in advance of adoption of the BIS-mandated capital adequacy requirement in Japan.

The Japanese banks' losses from the Crisis were small relative to their domestic loan losses, however. The paper suggests that Schilt's predictions regarding credit quality were accurate:

The rise of domestic problem loans in Japan to Y29.2 trillion ($232 billion) was threatening the stability of the financial system there as well. These problem loans would eventually be re-valued upward based on a new definition of 'problem loans' to Y76.7 trillion ($610 billion), representing 12 percent of total Japanese loans outstanding and equal to twice the size of Australia's economy.

While Japanese bank stocks held up much longer than bears had expected them to, bad loans were so pervasive that it was probably inevitable they would fall.

Saturday, March 7, 2015

Some popular investing techniques are flawed

Some popular investing techniques have drawbacks or complications that aren't readily apparent.


Specialization

Specializing in one industry or asset class gives investors the advantage of doing something they know inside and out, allowing them to develop an informational advantage over other investors. But it also has a big drawback: if an investor specializes in one thing, then he has to keep doing it regardless of circumstances.

In a Wall Street Journal interview from last year, venture capitalist Bill Gurley said that he thought venture capital was in the midst of bubble, but he also said that he continued to invest in start-ups because "choosing not to play the game on the field doesn't work."

During the early 1980s, an influx of money into venture capital increased the competition for deals and forced returns down. Unsurprisingly, many of the new funds that were formed during this period had bad performance. But as Jerry Neumann writes, the experienced venture-capital funds fared just as badly:

But poor returns weren’t limited to new VCs: returns broken out between first-time venture funds and follow-on funds show both the noobs and the experienced producing similarly dismal results.

This doesn't mean that venture-capital experience was worthless. Rather, I think it indicates the limits of specialization. The experienced VCs had raised funds for the specific purpose of investing in start-ups, so they had to invest the money even though competition had destroyed the opportunity to earn excess returns.

Another drawback of specialization is that it makes spotting bubbles harder. Financial markets are so vast that there's always a bubble happening somewhere, but within any particular industry or asset class bubbles tend to be infrequent. A generalist who has experience with multiple industries will recognize the signature of a bubble more easily than a specialist, who's likely to miss the forest for the trees.


Investing with owner-operators

Many investors assume that having an owner-operator at the helm of a company is a good thing because his interests are aligned with those of other shareholders. It's not that simple.

Owner-operators don't necessarily eliminate agent-principal conflicts. Some owner-operators have manipulated their companies' results in order to depress the share price and buy out minority shareholders on the cheap. And while it's true that owner-operators tend to create more value than agents, some of them take all of that additional value for themselves. Sardar Biglari, Ron Perelman, and Frank Stronach are notorious for enriching themselves at the expense of their companies' outside shareholders.


Shareholder activism

I expect shareholder activism to earn low returns over the next few years. In part that's because it's become a crowded strategy, but I think there are also structural reasons why it will fare poorly:

1. Most hedge-fund activists are bean-counters with little or no managerial experience. They may be right that a company is being mismanaged, but that doesn't mean they have the skills to manage it better.

2. My sense is that activism becomes more common as the economic cycle ages and valuations rise. When a bull market is in its infancy, there's less need for activism because stocks are cheap enough to deliver strong returns without improvements in corporate governance. Once valuations have risen and multiple expansion is off the table, investors need to see cost cuts, management changes, or similar actions to justify further appreciation.

3. As a result of 1 and 2, there's a "squeezing blood from a turnip" aspect to activism. Many activist campaigns are gimmicky: they involve calling for spinoffs, issuing debt to buy back stock, or doing something else that's intended to juice the stock price but doesn't improve risk-adjusted returns. According to an academic study, "[A]ctivism targeting purely capital structure or corporate governance related agendas earns relatively low returns."

At the risk of overgeneralizing, I think activists are most successful when they act as a veto on bad capital allocation at an otherwise-sound company.


Using other investors as contrary indicators

Few investors are wrong consistently enough to be good contrary indicators. I can't think of any offhand. I've frequently criticized Jim Rogers on this blog, but even he has made a number of correct predictions.

Many people who lose money over time do so because they rigidly adhere to a specific view regardless of circumstances-- for instance, they're bearish all the time, or they think every dip is a buying opportunity. Although these people are usually wrong, they aren't true contrary indicators because their opinions never change.

There's a self-congratulatory element to having contrary indicators that can be dangerous. It's tempting to look at an unsuccessful trader and think, "He's an idiot who always loses. I'm much smarter, and I'm going to prove it by taking the other side of the trade." Experience has taught me that this kind of thinking is a great way to make bad decisions and lose money.


Buying based on liquidation value

In theory a company that has significant assets can be liquidated, meaning that the value of these assets serves as a floor for the value of the company. In practice that's rarely true, for a variety of reasons:

• Liquidating goes against a business' nature. Corporate managers want to keep their jobs. Companies are oriented toward growth, or at least toward a steady state of doing business. No one starts a company while thinking ahead to the day when it will have to be liquidated because it's losing money.

• Liquidations take time. A company with $100mm of assets isn't worth $100mm if it will take a decade to sell all the assets.

• The point at which a liquidation is most attractive is also the point at which a liquidating business is least likely to get a good price for its assets.

Let's say you own a furniture store that's losing money because there's a recession. You think it's better to close the store and sell all your inventory than stay open and continue losing money. But the thing that makes it difficult to stay in business-- the recession-- will also make it difficult for you to clear out your inventory at a decent price.

• Even simple liquidations can be expensive. In 2008, I bought shares of a company called Soapstone Networks that made networking equipment. Its business was almost dead-- it hadn't sold any equipment in six months-- and I anticipated that the company would be liquidated.

Soapstone's balance sheet showed $6 per share of cash net of all liabilities, so I assumed it would return nearly $6 in a liquidation. When the company finally liquidated, the proceeds were much lower-- approximately $4.50. Operating costs, lease termination fees, professional fees, and severance payments ate a quarter of the cash.

Thursday, March 5, 2015

Before Dan Loeb became famous, he was "Mr. Pink"

Dan Loeb is the founder and head of Third Point, one of the world's largest hedge funds. Loeb became famous during the dotcom bust for writing a series of inflammatory letters to corporate executives he disliked, but his epistolary career began even earlier than that. From 1997 to 2003, he was a prolific poster on the Silicon Investor message boards, where he used the screen name "Mr. Pink."

Loeb posted more than 5,000 grammatically adventurous messages on Silicon Investor. There he referred to himself in the third person, usually as Mr. Pink, but also as "the Pinkster" and "PINK DADDY." As his audience grew, he became increasingly messianic, peppering his posts with references to "He," "Him," and "His flock."

I took a day off from my usual investing research to read his Silicon Investor thread, reading hundreds of his posts and skimming a bunch more. It was time-consuming, but it was worth it because the thread offers a rare window into the past that's free of hindsight bias.


Loeb’s investing strategy

During the late '90s and early '00s, Loeb primarily invested in small-caps. His mainstay was buying the kinds of special situations that Joel Greenblatt recommended in You Can Be a Stock Market Genius: spinoffs, demutualizations, post-reorgs, etc. He also shorted small-cap frauds.

These shorts were quite successful: even during the bull market from 1997-2000, Loeb identified many companies that fell precipitously. Chromatics Color Sciences, which was trying to develop a treatment for jaundice, doubled after he first mentioned it but ultimately went to zero. Agribiotech, a seed distributor that was being hyped as a biotech, went bankrupt within two years. Sirrom, an overvalued business development company with poor loan quality, blew up.

Actrade, a commercial-lending fraud, was Loeb's most notable short. He discovered that Actrade's Israeli-born CEO had fled to the U.S. to evade his creditors from a previous failed business, which the company hadn't disclosed in its SEC filings. Actrade went bankrupt in 2002, several years after Loeb first recommended shorting it.

Loeb had only one significant miss: in 2003 he recommended shorting American Pharmaceutical Partners because he thought its CEO was shady. The stock quadrupled in the following two years.

By contrast, Loeb's special-situations investments-- his bread and butter-- performed surprisingly poorly. There were some big winners, like First Sierra, Fingerhut, and Lennar, which all doubled in less than a year, and Agribrands, which doubled in two years. But by my count, his losers outnumbered them.

As many as half of the special situations he recommend eventually went bankrupt or ran into other serious problems: Cendant (accounting scandal), Consolidated Freightways (bankrupt), Fairchild Corporation (bankrupt), Federal Mogul (bankrupt), FPIC (doubled, then fell 90%), Hayes-Lemmerz (bankrupt), Loewen (bankrupt), Reliance Acceptance (bankrupt), Solutia (bankrupt), Ventas (fell 75% within three months), and Visteon (bankrupt).

Loeb's occasional macro calls also fared poorly. He thought Brazil would collapse in 1999 the way Russia had the previous year; instead its stock market doubled. He aggressively went short near the US market's lows in 2002 and lost money that year.


Playing the internet bubble

Loeb initially misjudged the internet bubble but eventually made money off it. He shorted Compaq in 1997 before it doubled. Later that year, when Amazon.com was trading at split-adjusted $4, he told another poster, "You are very wise to be short AMZN. Mr. pink could not obtain a borrow in sufficient size so could not do it."

He expressed similar sentiments about AOL in 1998, right before its speculative blowoff: "AOL is the worst offender of accounting shenanigans. It takes balls but is a good short. Mr. pink has no position yet, but it stinks."

But by the end of the year he'd changed his opinion: "Thou shalt not short internet stocks.... It is impossible to pick the top of a bubble."

Around that time, he began buying small-caps that had low P/E ratios and hidden internet subsidiaries, assuming they would rise when day-traders discovered the internet connection. He did this successfully with four or five different stocks, making quick 30-50% profits on each one.


Playing subprime lenders

As with internet stocks, Loeb played subprime lenders as both a long and a short. His subprime investments were generally profitable.

In 1997 he lost money buying Reliance Acceptance, a subprime-lending spinoff that went bankrupt soon after he recommended it.

In 1998 he shorted FirstPlus, which had grown quickly by making 125% LTV home-equity loans. FirstPlus collapsed after the LTCM crisis and went bankrupt in early 1999. A Businessweek article gives a sense of the company's lending practices:

Gene T. O'Bryan, former president of FirstPlus's wholesale lending division, who left in March, 1997, says in some cases, mortgage brokers who sold to FirstPlus simply made a series of ever larger loans to the same customer. And by paying off the old debt, borrowers who were going deeper into hock managed to improve their credit ratings. FirstPlus barred such refinancing, but "nobody checked," he said.

Loeb recommended shorting Long Beach Financial in late '98. Washington Mutual acquired LBF at a 100% premium the next year. Regarding subprime credit-card issuer Providian, he told another poster to "Short it with impunity" around the same time. Like Long Beach, it doubled the following year.

He ultimately made money on Providian when it nearly collapsed in 2001. He also made money shorting Conseco, Metris and Americredit in 2001 and 2002.


Skill versus environment

Loeb earned 40-50% annual returns in the late 1990s when his fund had less than $100mm in assets under management. I think this success was a result of size and environment in addition to skill. For many individual companies his analysis was wrong, as demonstrated by the high failure rate of his long picks, but he was still able to earn great returns because he was exploiting a couple of niches-- special situations and small-cap frauds-- that were overlooked and mis-priced in the aggregate.

The Young Money guide to short selling

The title of this post is an overstatement: this isn't a comprehensive guide to short selling. Instead, it's a description of how I think about shorting and what I look for-- and avoid-- in a short.

My style of short selling is very different from the one most hedge fund managers use, so hopefully this post will provide a useful variant perception, but I don't claim that this is the One True Way to short stocks.



My favorite shorts

There are two dynamics that I look for in a short. The first is an industry-wide expansion that's been financed with debt. To generate the cash they need to service this debt, industry players have to keep producing even when doing so doesn't yield economic returns. This is self-defeating and leads to severe, prolonged gluts.

Iron ore miners, and mining companies more generally, provide a contemporary example of this dynamic.

The housing bubble provides another example: most homebuilders took on a lot of debt to buy land. When the bubble burst, the land market froze up, leaving them with large inventories they couldn't liquidate. The only way they could monetize their land and pay back their debt was to build more houses, which exacerbated the downward pressure on house prices.

A similar dynamic occurs when companies have to sell leveraged assets. The Lehman Brothers bankruptcy examiner's report explains why Lehman's effort to sell its toxic assets was self-defeating:

But if the need to reduce leverage forces the sale of illiquid assets at a loss, it has a double impact; in addition to the loss, the perception can be that there is "air" in the valuation of the other illiquid assets that remain on the balance sheet, exacerbating the risk of a loss of confidence in the firm’s future.

The second dynamic I look for is failed exponential growth.  In Irrational Exuberance, Robert Shiller writes that "naturally occurring Ponzi processes" are a defining feature of asset bubbles. Since Ponzi schemes pay their existing investors with money from new investors, they have to grow exponentially or else they'll collapse. While asset bubbles aren't fraudulent, they follow a similar growth-until-collapse trajectory.

A necessary ingredient of the housing bubble was that mortgage lenders continually relaxed their lending standards, allowing a larger and larger group of people to buy houses. Eventually they ran out of remotely decent borrowers and began lending to people who were so marginal that they defaulted on their loans within a few months. At that point many subprime lenders failed and the rest pulled back, starving the bubble of the exponential growth it needed to sustain itself.

Something similar happened during the dotcom bubble. In early 2000, tech stocks traded at high P/E ratios because they were growing quickly. But by then the marginal buyers of high-tech products were money-losing competitive local exchange carriers and dotcom startups. Many of the CLECs and dotcoms had no real business plan and went out of business within a couple years, ending the dotcom bubble's exponential growth. They were the final, marginal buyers of the dotcom era, like subprime deadbeats were the marginal buyers of the housing era.

Conventional wisdom says that shorting a bubble is too risky. I partially agree-- catching the exact top of a bubble is difficult, and there's a severe penalty for being early and shorting into exponential growth. I never short a bubble unless I'm convinced that its exponential growth trend had failed.

In my experience, though, there are usually great shorting opportunities even after the trend has clearly failed. By September 2000 it was clear that the CLECs and dotcoms were goners, but the NASDAQ 100 was only 15% off its all-time high. By February 2007, the whole subprime sector had already imploded, but leading homebuilders were only 20-30% off their highs and XLF, the financial sector ETF, was less than 10% off its high.

The market offers opportunities like this because few investors understand the extent to which bubbles are like natural Ponzis and will collapse without growth. Most investors are backward-looking and extrapolate recent years' performance forward. Every bubble has periodic shakeouts that give way to further appreciation, and these shakeouts train people to buy the dip. There are also some people who missed the bubble and are anxious for their chance to get in, and when the bubble finally bursts they think their opportunity has arrived.



Less-favorite shorts: frauds

Short sellers often target companies that they think are committing fraud. This is a viable strategy, but it has several under-appreciated risks:

• It's become very crowded. Frauds are arguably the most popular kind of short nowadays.

• Occasionally a company that looks fraudulent turns out to be legitimate and the stock surges. Robert Friedland and Patrick Soon-Shiong were both dogged by controversy during their careers, yet they both managed to create and sell multibillion-dollar companies.

• There's a bigger macro component to fraud-busting than most people assume. Enron didn't collapse until the entire merchant-energy sector experienced a liquidity crisis. (Edit 4/4/15: This statement is incorrect. While Enron went bankrupt during a period of rising bond spreads, the merchant power sector didn't experience a severe crisis until mid-2002, six months after Enron's bankruptcy. Mea culpa.) Allied Capital was able to continue its Pozni-style growth for years until the Global Financial Crisis prevented it from raising new money.



Shorts I don't like and don't do

• Overvaluation
Short sellers sometimes argue that a company will never be able to grow into its valuation. In my experience, companies that trade at exorbitant valuations because they're growing quickly keep trading at exorbitant valuations so long as they keep growing quickly. And occasionally a company does grow enough to justify a steep valuation, e.g. AAPL and HANS/MNST.

Some companies have structural reasons for being overvalued. RGLD invests in gold-mining royalties and has always traded far above NAV. It's sustained a large premium to NAV because it offers yield and good capital allocation in an industry that's notorious for offering neither.


• Aggressive accounting
Companies with liberal accounting innovate more. Investors typically look only 1-2 years into the future, so they often won't support a project that has the potential for strong long-term returns but requires a lot of upfront investment. Creative accounting gives companies a way to invest for the long term while meeting short-term expectations.

Other factors can outweigh the effects of aggressive accounting. If a company overstates its earnings by 10% but grows earnings by 30% a year, which is more important?

Aggressive accounting may be a sign of deeper problems, but by itself it's not a reason to short.


• Promotional management
Management may be promotional as part of a strategy to get their product more visibility or raise money on better terms. Like aggressive accounting, promotional behavior is a red flag, but by itself it's not a reason to short.


• Perception shifts
in 2008, I shorted a basket of companies with negative tangible book value. My rationale was that there would be a recession and financial crisis, which would lead to investors and lenders becoming more conservative, and companies with no net worth would go out of favor. This basket was marginally profitable, but it made me a lot less money than my housing and finance shorts.

The difference was that housing/finance stocks were being dragged down by a macro process that had already begun and that I knew would continue. By contrast, the basket trade was based on my vague anticipation that a recession would change people's perceptions of indebted companies.

I made the same mistake last year, shorting POST and VRX on the assumption that people were overvaluing them because they were "Outsider companies." Like in 2008, these detracted from my macro shorts.


• Small-caps and crowded shorts
In 2009, I shorted a Spanish bank called Banco de Valencia. Regulators eventually seized the bank and its stock went to zero, but I didn't make any money because I got bought in at a 10% loss. I was beside myself watching the stock's subsequent decline.

The risk of a buy-in doesn't automatically make something a bad short, but I'm not able to handle the frustration of being bought in, so I don't do it.


• Acquisition targets
I shorted Rio Tinto the day before BHP Billiton offered to acquire it. I also started looking at Consolidated Thompson as a short a couple weeks before CLF acquired it. Those experiences have made me paranoid about shorting acquisition targets. Like shorting stocks with a high buy-in risk, it's just too stressful for me.


• Increasing competition
Increasing competition won't necessarily hurt a company that has differentiated products. AAPL and LULU have fended off a lot of deep-pocketed competitors.

In a commodity industry, increased competition inevitably kills margins, but it can happen with a years-long lag if speculators hoard the commodity. Since 2009, there have been frequent reports of copper being stockpiled in Chinese port warehouses. I think this has kept copper and mining equities much higher than they otherwise would be.


• Structural handicaps
Short sellers sometimes argue that a company has a fundamental flaw that prevents it from earning decent returns: its competitive position is too marginal, its cost structure is high and impossible to bring down, or its management and corporate culture are terrible.

Shorting companies like this has a couple of drawbacks. First, companies that are doomed to produce poor long-term returns sometimes achieve decent short-term returns. History gives us many examples of companies that temporarily turned around before failing.

Second, structural challenges can take a long time to translate into lower earnings. Tesco fell nearly 50% last year, but it was flat for years before that as problems-- the Fresh and Easy debacle, competition from Aldi's, etc.-- piled up. Someone who shorted TSCO in 2007 has a mediocre annualized return and had a 0% annualized return until last year.

In a 1987 Barron's interview, Julian Robertson recommended shorting Winn-Dixie because it was a high-cost player facing competition from low-cost entrants. Robertson was right about Winn-Dixie's future-- competition eventually bankrupted it-- but its stock rose significantly during 1990s despite its weakening competitive position and didn't peak until 1998. It paid large dividends the whole way up.


• Disruptive innovation
Disruptive innovation is a long-term phenomenon, and cyclical phenomena can overwhelm it in the short term. ETFs are steadily taking share from mutual funds, which are likely to fade away until they're a small niche product, but that hasn't stopped TROW from quadrupling since the stock market's March 2009 low.

FSLR is the only major company that invests in making Cd-Te solar panels more efficient, whereas there are many companies investing in polycrystalline solar. I'm skeptical that Cd-Te has much of a future, but that didn't stop FSLR from surging 1100% in the year after its IPO.

The Internet began disrupting newspapers in the 1990s, but newspaper stocks didn't peak until 2004.



Arguments against shorting

"Shorting is hard."

Many hedge-fund managers say that shorting is difficult and that they've never been able to earn sustained profits for it. There are two reasons for this:

One, they're using a crowded strategy and piling into crowded shorts. Most funds emphasize fads, failures, and frauds in their short book. Most funds short all the time as part of a low-net-exposure strategy, even though opportunities for shorting vary across the market cycle.

Two, they short because that's what hedge funds are supposed to do, not because they have a talent or inclination for it. As Whitney Tilson writes, "Most investors expect hedge funds to have a short book." Instead of striving to satisfy investors' unrealistic expectations, why not invest that psychic energy into looking for better investors?


"The market goes up over time."

There's no guarantee that it will continue going up. The Nikkei is 50% below the all-time high it reached 25 years ago. I expect US markets to be lower five years and ten years from now.

Even if the market goes up, it's likely that a minority of stocks will account for all of the long-term gains, with the rest treading water or going down. As Carlo Cannell says in his Value Investor Insight interview:

If you really track the mortality rates of companies, you’d conclude that the market does not have the upward bias everyone thinks it does. The market is actually a carefully pruned garden.

Many industries and emerging markets have fallen over the past five years as the broad market has surged. The same thing happened during the late-1990s tech bubble. Even in a bull market, there are sometimes good short opportunities.


"Shorting is stressful."

This is definitely true. David Merkel argues that being short is like having a leveraged long position, since they both involve the risk of losing more than 100%. Someone who isn't comfortable using margin debt probably shouldn't short.