Short selling isn't viewed favorably by all investors, but there are many different reasons different types of investors might want to short a stock or stock index. On one end of the spectrum, one might think of the "conviction short seller" who aims to identify individual stocks likely to fall by 50% or more, often falling into a category of fads, failures, or frauds. On the other end of the spectrum are what I call "statistical short sellers", whose aim is more to reduce beta exposure of their overall portfolio, and add some factor alpha by shorting a diversified portfolio of overvalued or otherwise relatively weak names. While my colleague Anand Batepati focuses on the former approach to short selling, I have long preferred the latter approach to the short portion of my portfolios. Only recently have I started finding it worthwhile to spend more time examining and explaining some of the deeper factors for including (or excluding) even a 0.5 - 1.0% short position in a name.
This article presents some of my best and worst short positions of 2019 so far, in the format of a "quick picks" or "lists" article. The first two shorts are ones I wrote earlier articles on, while the others we have so far been short for about six months so far and not yet written on. The point of sharing these short selling notes is to reflect on which factors have worked so far this year in selecting profitable positions, and which may need to be revised in choosing to keep these or add new shorts.
I first wrote just over 2 years ago in September 2017 about the 7 C's of why Tesla shares would probably crash. Our current short positions in Tesla, Inc. (TSLA) shares were initiated in November and December 2018 at average prices of around 356 and 374 respectively. Since then, Tesla has continued to report loses, issue more debt, and dilute its shareholders by issuing more equity, and seen an expected multiple correction from a Price/Sales ratio of over 3x late last year to just over 1.5x today. We continue to believe Tesla shares are overvalued versus their most likely future cash flow scenarios, but have been preparing to cover this short by selling out-of-the-money put options against our short position.
Netflix Inc. (NFLX) was a somewhat more challenging short to consider, given that the company does have very valuable proprietary content and user data, but as I explained in my article earlier this year, Netflix remains an A-rated business at an R-rated valuation. The analysis and decision on this name, as with Tesla, largely revolved around a simple spreadsheet calculation of what future scenario would have to play out in order for buyers of these shares at current prices to even get their money back, let alone a positive rate of return. A reverse DCF analysis would imply subscriber growth and pricing power, especially into markets like India, I believed were way too optimistic and more likely than not to disappoint. Our current short position was entered into over November and December 2018 and January and April 2019 at prices of around 286, 294, 314, and 369 respectively. As with my worst short so far this year (described at the end of this article), at every point we needed to evaluate whether to hold our short, add to it, or cut our losses, especially given the added risk of losing shorts automatically becoming larger positions. The decision to add until April was due to a combination of a.) conviction in my analysis, b.) an expectation that downside was limited, given how hard it would be for NFLX to grow to a market cap of $300 billion, and c.) an understanding that the rise from 286 to 369 was mostly due to multiple expansion (from a Price/Sales ratio of around 7 to around 10), rather than from any actual improvement in Netflix fundamentals.
As with Tesla, we have started preparing to cover and take profits by selling out of the money put options against this short.
DropBox Inc. (DBX) is a company I have long believed should trade at commodity-level valuation multiples (say, less than 20x earnings, or at a PEG far less than 1), given its business of providing a completely commoditized service (cloud-based disk storage). I all too well remember the handful of other cloud and pre-cloud storage sites I have used over the years that have come and gone, one memorable example being Xdrive. I now back up my files three parallel services: Amazon's S3, Microsoft OneDrive, and one local service, and I have gotten so used to redundancy that my switching costs are not much more than zero. I am certainly not Dropbox's typical customer, who probably prefers a more user-friendly interface on top of Amazon Web Services (on which Dropbox used to run, but has since saved some costs since building their own cloud), but as I've seen with Xdrive, switching costs are too low for Dropbox to retain much pricing power and justify its current valuation. We entered our short DBX position in April of this year at around 22.40.
As a long-time SQL nerd, I felt like I had at least average understanding of the prospects of open source NoSQL database software company MongoDB Inc. (MDB). MongoDB is perhaps the leading NoSQL (meaning "not only SQL") database software serving as an alternative to more traditional SQL ("structured query language") databases powered by the likes of Oracle and Microsoft. As a part time programmer myself, I see some appeal of this more modern type of database server, but not enough to justify enough customers to switch from SQL databases or pay Oracle-level fees anytime soon. At a Price/Sales multiple of over 25x at the time, I saw more downside than upside in this company for as long as it continued to bleed cash and fail to prove a path to profitability. We initiated our current short in April this year at around 145, and continue to review whether to hold it.
Cronos Group Inc. (CRON) was the first of two names in the marijuana / cannabis sector we added to our short list. After months of heavy publicity covering both individual stocks and ETFs in this space, as well as being approached by several funds raising money to invest in this space, it raised flags as a sector that was likely overhyped. I especially found it puzzling that a few commentators who would uncritically exclude tobacco in one breath, would seem to favor in the next breath a weed that could still get traffickers hanged in many Asian countries. Also on our short checklist was the fact that this company has never made money, that it covered all its 2018 cash bleed by issuing debt and shares, and that we could not find any proprietary advantages (its website uses words like "disruption" and "innovation", but I could not find any clear examples). We entered this short in April this year at around 16.90, and would consider taking profits and rolling into an even more inflated name in this space if we can find one.
Our second marijuana short this year was Canopy Growth Corporation (CGC), which at first looks very similar to Cronos: losing money, negative operating and investing cash flows are only covered by financing cash flows, and with a website long on buzzwords and seemingly short on substance. The biggest difference I could see between the two was that unlike Cronos, which used some debt financing, Canopy seemed to be financing itself almost purely by issuing new shares. We executed one short trade on April 12th at 41.47, and are similarly considering covering and rolling when ready.
Perhaps the only thing better than having a 7-0 record on shorts in a year is having one good losing position to keep me humble and remind me to be careful about risk management and downside even when a short seems to tick most of my boxes. This year, my worst performing short position has been in the Canadian e-commerce platform Shopify Inc. (SHOP), which I shorted in April at around 212.80, when it was trading around 20x its 2018 top line revenue. SHOP has since risen to over 30x TTM sales (which are up only 20% from 2018), another example of valuation multiples rising faster than underlying fundamentals. Like those who shorted Tesla or Netflix years ago, I believe I may have been a bit too early on this one, and that the odds are still in favor of the shorts given continued losses, stock issuance, and the ease I see in opening online businesses on competing platforms. The last point is one I believe helped drive down Dropbox and MongoDB in my favor, but here, it may be that the Shopify customer is sticker than the other two, and perhaps my own comfort writing HTML makes it harder for me to appreciate that.
Given the high valuations of US-listed stocks, and late stage of the current cycle, I believe it makes sense for more portfolios to consider adding a diversified mix of statistical short positions. Names like these are likely to fall more than the market in the next down turn, and should on average underperform gains on the long side even in an up year like 2019. I believe the 6-1 winning rate of these shorts is perhaps more fortunate than I should expect most years, but that looking for overvalued and vulnerable names in overhyped sectors provide a valuable ballast to a portfolio, especially when fears of market highs seem at their heights.