Evil Knievil’s Guide: Successfully Shorting Stocks

Simon Cawkwell aka Evil Knievil lives in West London and has successfully navigated the markets for nearly 45 years. Although he started working life as a chartered accountant, he came to prominence with the collapse of the infamous Robert Maxwell’s affairs where he cleared £250,000 profit some twenty years ago – no small sum back then. His specialisation is short-selling and he is a self confessed inveterate gambler.

Cawkwell famously made £1 million by short selling shares in Northern Rock when it collapsed, but he also but also utilises his accounting knowledge and vast experience to buy shares. But like the rest of us he sometimes gets it wrong, once losing a substantial sum shorting the office provider Regus. One thing’s for sure he doesn’t pull punches and tells it as it is!

Simon Cawkwell aka in the City as Evil Knievil

Tips from a short seller

  1. Never buy shares with high valuations in relation to tangible net asset value.
  2. They can swan along and upwards for years but they have no cushion for the bad times.
  3. Never short-sell stocks when they are going up.
  4. Wait until they are going down and never hesitate to kick them down should they be so impertinent as to make an emotional appeal for help.
  5. Always treat any stockbroker who is remunerated with commission as a compulsive liar.
  6. Work on the assumption that all regulators are completely useless.
  7. Except, that is, at concealing their own incompetence such that the money you pay them for their ‘services’ cannot be reclaimed.
  8. Be very suspicious of all mining companies run by stockbrokers.
  9. But do not hesitate to buy such companies when they are new to the market. There is an infinite supply of fools to buy after you.
  10. Accept that all men always lie…but try to lie as little as possible.
  11. When a man says that his word is his bond…take his bond.
  12. If you do not understand an investment, prepare to short it.
  13. There will always be a large number of gormless idiots who will have to sell after you so guaranteeing you a profit.
  14. Borrow when others are not borrowing . Repay when others are not.
  15. Never hesitate to bet against an odds-on favourite.

First, let me stress that ‘shorting’ is still very much a minority occupation of spreadbetters and I find comfort in being in the minority. If ‘fire’ is yelled in the cinema, you will find me waiting for a moment, finishing off snogging the usherette and then running the opposite way of the crowd. Whilst it is of course dangerous to go against the herd, particularly in stocks where momentum is very powerful (and which I found out personally at a seven figure cost in the now collapsed Connaught – even though I was ultimately proved right), as with the cinematic fire analogy, when the crowd has made their move and is rushing to get out of one exit, taking the opposite approach in many instances proves to be the right thing to do.

Another thing that I have noticed over the years is the curious phenomenon amongst retail traders in particular to become excited about a stock as it falls. Witness just how popular the bulletin boards of once revered names such as Connaught, Thomas Cook, HMV, JJB, Man Group and BP (at the time of the Macondo disaster) are, or were, as they fell ever further. The lure of a bargain never fails to tempt the majority. What many people fail to realise however is that just because a stock price was say 200p yesterday and has fallen to 100p today, for example as a result of a profit warning out of the blue that has changed the company’s outlook materially, does not necessarily mean that it is now worth buying.

Statistics show that when a company falls by a figure greater than 20% on any one day and that the stock price decline is specific to it, i.e. not being dragged down through a market-wide crash, fewer than 10% of such stocks are higher some 3 months later. Falls of this magnitude are almost always caused by company-specific adverse news which in turn causes the primary market movers – the fund managers – to react and, nearly invariably, to sell.

Profit warnings in particular are the main culprits when it comes to a stock falling sharply and there is a City adage that when one profit warning is made, given that they generally “come in threes”, there is a further two on the way. Sell first and await concrete encouragement to buy is the wiser City way. Retail traders typically fail to recognise that when a company releases bad news and its share price is generally de-rated, it can take a number of years for the stock market to trust the company again. BP currently pays testimony to this – before the Macondo disaster the PE ratio of the stock was some 40% higher than today (adjusted for the anticipated exceptional litigation and cleanup costs of the disaster). Another observation is that if a company is trading on say 15 times expected earnings and the company unfortunately releases news that growth has slowed and that earnings will fall by say 30% from current expectations, its share price will fall by a greater amount than the earnings decline. The truth is that investors overlook the magnitude of this news and jump in, mistakenly believing that the stock cannot fall more. I remember BP falling from 600p to 500p then to 400p and the consensus believing that there was no more downside. But the stock ultimately fell to sub 300p at which point many margined players were flushed out. When a stock releases bad news and falls sharply, the downtrend will, in the vast majority of cases, persist. Do not jump in with the crowd and be swayed by the price such that one buys.

Now, knowing the above, and being aware of modern market dynamics where the principal change in recent years is the much greater level of leveraged trading in the market, we can consider those factors that will tip the odds of a successful short in our favour –

When and how did you take the plunge to the dark art of short-selling?

The optimum time to get short

One should always pay heed of the overall market environment. For example, if we are in the early stages of a bull run, shorting companies, particularly mid and larger cap stocks with high betas, is likely to be a fruitless or loss-making exercise even in the case of poorly managed companies. One has to be reasonably confident of a discounted cash-raising to ignore these conditions.

The adage “a rising tide can lift all ships” is what will very likely sink the amateur shorter in this environment. In the early to mid-stages of a bull market, even companies that appear to be an ideal candidate for a short position can rally sharply as the greed-fear pendulum begins to shift in favour of the greedy. Similarly, at bear market troughs you generally find that the so called ‘trash’ will rally the sharpest after the blue chips have initially risen in price as investors chase the lesser quality stocks in a catch up exercise.

The ideal environment to place your short is one of overall investor complacency, low volatility, elevated valuation levels and ideally a mature bull run that has become accepted as the norm. It is characterised by ever greater speculation levels by the retail investor. At this point, the successful shorter gets the added benefit of a tail wind as the general market eventually lurches lower.

The lower down the market cap spectrum, it is reasonable to expect the amplification of the stock fall since the potential for radically altered perception is greatly increased. Low market caps usually equal low liquidity meaning that when people actually need to get out, i.e. through margin calls or complete fear taking over them, those hard-hearted market-makers most certainly will not hold the bid and allow an orderly exit. This is a good moment to think about reducing your short position since most are running for the exits – if I may return to the fire-stricken cinema analogy.

The first profit warning, particularly in a highly rated stock, be it a pharmaceutical company that disappoints on a drug story, an oil explorer that hits a duster or a technology stock that warns of slowing growth (Facebook perhaps?) is the point at which you seek to get short and stay short. Do not however go all out on the opening price. Sell perhaps half of what you ultimately intend and on any intra-day rally and over the succeeding days look to add to your position. This inhibits excess enthusiasm.

The final important element in relation to this section is that you should wait for the trigger to short and not try to anticipate it. For example you may believe Facebook is overvalued but blindly shorting it because of this could prove a very expensive and stressful exercise initially. The case study of Netflix illustrates this point in that the respected US hedge fund manager Whitney Tilson sold the stock short in the middle of its uptrend believing the company overvalued and the balance sheet flimsy. His analysis was correct but he was trampled by the herd. You can guess the rest, having sold short around $200 he was forced to cover around $300 – around 5% shy of the high. The next stop was $60 just 4 months later. So do not get in the way of the oncoming locomotive – wait for the downturn before placing your short.

Be aware of the pendulum of greed and fear and use it to your advantage

It is eternally true that investor emotions always swing between the extremes of greed and fear. In the past 12 years we have seen the following phases. First there was the internet-based mania which gave way to despair after the 9/11 attacks. This was followed by heady times on the run up to the Lehman crisis which in turn led to the depths of the spring of 2009. Since then we have had the Eurozone crisis whose solution seems to be accompanying a bull market. Please notice that bear runs generally take about eighteen months to play out and that stocks are rising in a bear market two-thirds of the time.

When it comes to shorting individual companies, being aware of the greed-fear pendulum will assist you in getting on the right side of this emotional swing. Wait for the catalyst as described above and note the pendulum as the evolution of emotional disbelief, caused by the first fall, turns to resigned acceptance which is generally coupled with the hope of a turnaround in fortunes. This finally gives way to revulsion and despair and leads to capitulation and the last sales.

This understanding of the cycle illustrates why shorting an overvalued stock that is still very much on the greed swing of the pendulum will typically prove a painful endeavour.

Earnings are malleable, balance sheets less so whilst cash-flow cannot hide the truth

Time and again I have seen companies manipulate earnings through playing with depreciation and amortisation values to flatter profits, acquiring other companies on lower earnings ratings through the issuance of more of the acquirer’s overvalued paper, to classifying ‘above the line’ charges as ’exceptionals’ .

What management cannot manipulate however is cash flow. The all-important ‘Net cash flow from operating activities’ is the key measure to watch as this tells you accurately how the business’s day to day activities are performing – a negative measure here will herald either consumption of existing cash resources or raising of new finance by way of equity or debt or sales of assets. A business that is suffering from declining top line revenue and that has negative net cash flow from operating activities and, ideally, has a large debt burden is an ideal short candidate.

Similarly Net Assets can be inflated through Intangibles. Of course, when it comes to technology orientated stocks that rely on proprietary software that has been created over a number of years and that is patent-protected, intangibles can, quite rightly, be capitalised and will no doubt have a tested ‘economic’ value to the company. A good example of this was Autonomy that that did not have a large amount of tangible fixed assets but whose patented encryption software generated exceptional profitability such that Hewlett Packard was prepared to pay a very substantial premium for the company – in effect validating Autonomy’s intangible balance sheet valuation.

However, I look for a business that has negative cash flow, minimal room for error by way of available financing, and whose balance sheet is inflated with intangibles – typically through unjustified goodwill. The more ‘ducks’ you can line up in a row with regards to the tests to look for in shorting a stock, the better. The balance sheet and cash reviews are an integral part of the process.

Have the courage of your convictions and be comfortable in the minority

Bearing in mind my observations in points (1) & (2) last month regarding the most fertile backdrop to look for in taking a short, and assuming one has done one’s homework and that you are short, the trick is to control the emotional side of the trade.

One can be caught out by an out of the blue bid. Thankfully, this is a rare occurrence, but nevertheless there is an amazing amount of hubris and stupidity displayed by company directors, and the lure of a bargain can tempt a move on an ailing business. In this instance, depending on your spreadbetting firm and their offers of ‘Guaranteed Stops’, it pays to use a guaranteed stop to lock profits on the way down and protect yourself from the possibility of a 30-40% gap up. The ‘guarantee’ is generally set at a minimum of 10% from the current share price and is typically only offered on the top 350 stocks.

If you are on the right side of a short position, the short tack should hopefully be a relatively lonely existence. The more there are loud voices on the bulletin boards and in the press proclaiming what a cracking buying opportunity this stock is, the better. Experienced traders have time and again witnessed what happens in the early stages of a bear market; the media and investors in general, so conditioned by the recent rise in prices, believe that the first pull back is yet another buying opportunity. This buying into the decline generally continues.

That this buying is contrary to experience is evidenced by the fact that the 1, 3 & 12 months’ biggest risers’ and fallers’ lists, which you can find in publications like the FT, disclose that the biggest fallers generally display a continuing theme in that they persistently feature in all three lists. This bears out the adage that ‘the trend is your friend’.

Be aware of borrowing restrictions, particularly when a company is in its death throes.

This is an important technical point that can catch out the novice shorter. To understand the development of the problem, it is important to appreciate what happens when you short a stock.

Your spreadbet firm will sell the actual stock in the market. On the other side of this, there will be a buyer, who will need delivery of stock. Therefore the spreadbet firm has to borrow stock from an institutional lender.

Incidentally, the institutions which lend out their stock receive a borrowing fee in exchange for this that than can vary from less than 1% per annum to double digits, depending on how much the stock is in demand to be borrowed.

The institution that has lent out the stock may, at some point, wish to actually ‘call the stock back in’. This means that your spreadbet firm, in the absence of being able to find a new borrowing avenue, will very likely require you to close your short, i.e. buy back the shares in the market so that these can be delivered back to the lender. If there are no ready sellers of stock for whatever reason, there can be a mad scramble for stock. What can now occur is the dreaded ‘short squeeze’.

In the UK it is quite difficult to get accurate ‘stock on loan’ data. Therefore you are more at risk of a sudden call from your spreadbet firm asking you to cover your position than might be the case in overseas markets. In the US there are a number of websites that show stock on loan data such as here – http://www.nasdaq.com/symbol/amsc/short-interest

Another lesson here is that, if you have made 80-90% of the potential fall, do not be a stubborn theorist. Instead, do look to take spoils off the table, i.e. if you have shorted at 100p, say, and the stock is presently priced at 20p, don’t be hero and look to take the last scraps and expose yourself to a short squeeze.

I caution against going short of minnows, i.e. stocks less than £10m in market capitalisation. Aside from the fact that you’d be hard pressed to find a spreadbet firm that would take on this trade, price spikes can be material. It is best to leave these alone unless you have a profound indifference to adverse fluctuations.

Covering your shorts

And so we come to the all-important short covering element. Basically, there will be 3 primary buy back reasons. They are:

(i) you are stopped out by way of a price rise that has triggered your own personal money management parameters (hopefully with a stop loss guarantee in place).

(ii) the stock no longer offers an attractive risk/reward profile. A banked profit feels much nicer than a paper profit.

(iii) Finally, in the immortal words of John Maynard Keynes, ‘when the facts change, I change my mind. What do you do sir?’ If the reasoning for the short changes, and leaves the argument to be short in doubt, close the short. Be warned that most investors are indecisive when confronted with this problem.

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