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The Dark Side


At any point in time the value picks are far outnumbered by shorting opportunities. This is because 1. more companies fail than succeed (even fewer beat cost of capital) and 2. there are multiple institutional biases against shorting. Although the path from identifying the short candidates and the execution of the trade leading to capitulation can be torturous. 

Following are three, non exclusive, frameworks for identifying shorts:

Kathryn Stanley
Trail Signs / Triggers
Management lying or obscuring eventsAccounting Gimmickry
Inflated stock price / speculative bubbleInsider sleaze
Deteriorating macro environment for the companyStellar price rise

Cash burn / Deteriorating balance sheet


Scott Fearon / James Montier
Trail Signs / Triggers
Fraud          (Bad Managers)Overvaluation
Fad             (Bad Companies)Deteriorating Fundamentals
Failure        (Bad Strategies)Poor capital discipline

Bad accounting

Jim Chanos
Debt financed asset bubbles
Technological obsolescence
Bad Accounting / Balance Sheets
Consumer fads

The most difficult part of shorting is - Timing. Short sellers can and often do underestimate the madness of crowds. Ability to raise capital, sell side analyst support and a general suspension of rational thought process can keep the shorts elevated (or even rallying) for an agonisingly long time. Covering in case the stock runs up more than a specified limit (25% for example) and reassessing the thesis can be helpful. An alternative is to have a small manageable position and pile on when the momentum breaks. Both entail costs and risks. 

Some errors to avoid:

          1. Not covering when facts change
          2. Not doing enough background work / shorting ideas of others 
          3. Shorting "good" companies 
          4. Panicking at the worst time

Predefined strategies help. 

References:

Art of Short Selling, Katheryn Stanley - The most entertaining and informative book on the subject


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