It is true that you should never ask a barber if you need a haircut. Nevertheless, I am going to argue, on behalf of my peers, that in an environment where low returns are the corollary of high asset prices, as well as the best-case scenario for most investors, any strategy that can to add alpha from short-selling needs to move from the ‘alternative’ space into the mainstream.
The returns that many investors have made from blindly buying infrastructure, utilities and large cap, high-dividend yielding stocks (none of which we own) are ephemeral and transitory in nature.
Before considering an alternative approach, let me set the stage. The income recession in term deposits has triggered an investor migration into those company shares with lower perceived earnings and dividend volatility. The problem of course is they tend to be the large-cap (conventionally described ‘blue-chips’) or infrastructure and utility companies.
In the case of the big blue chips, the S&P/ASX 200 dividend payout ratio has increased from 55% in 2010 to 80% today. Paying out more of the profits in dividends means retaining less for growth. In other words, investors are paying high prices to buy bond-like returns, but are adopting equity market risk. History has always punished this strategy.
New normal is anything but normal
In the case of infrastructure and utility companies, the valuations are high because interest rates are low and most of these companies have little or no net equity on their balance sheets, so valuations are boosted through the weighted average cost of capital calculation.
We have therefore arrived at a new normal that is anything but normal. The most expensive companies are those with little growth or a lot of debt, or both. As we have previously stated, low interest rates corrupt everyone’s sense of risk.
Elsewhere art, vintage cars, low numeral licence plates and wine are breaking record prices in auction rooms characterised by standing room only and frenetic bidding.
Additionally, Aussie investors have leveraged-up to chase asset prices higher, particularly property, increasing their debt burden to 185% from 170% of disposable income since 2008.
A role for short-selling
The mathematician Herbert Stein once observed, "if something cannot go on forever, it will stop.” Investors, however, are not only ill-prepared for any reversal, they are ill-equipped. All of their investments are in assets that benefit from rising prices, and thanks to the 30-year decline in interest rates, not only have investors enjoyed rising asset prices, but they’ve been lulled into expecting those returns to continue.
Buying low and selling high, in that order, is the common way to generate wealth and preserve purchasing power. If, however, asset prices do not produce a large positive between the purchase and sale, and bouts of sharply declining prices ensue, selling first and buying later at lower prices, (or short selling as it is known), may not only enhance the possibility of greater returns but may also smooth them.
Short-selling receives a great deal of attention thanks to a practice of ‘shorting and distorting’. For some investment managers their business model involves not only establishing short positions in certain companies, but also attempting to accelerate the returns by promoting the negative thesis widely. Bill Ackman’s short trade in Herbalife through his firm Pershing Square is perhaps the most recent high-profile example of ‘activist’ short selling.
Critics of short selling often argue that practitioners delight in the demise of businesses and industries and some go so far as to suggest that they are the cause. From Kerr Nielsen at Platinum to the teams at Perpetual and BT however, short selling is not the exclusive domain of malicious hedge funds intent on wreaking havoc. A large number of funds count themselves among those that seek to generate uncorrelated returns for their investors or offer some insurance from declining markets and sectors.
Short-selling is simply the act of borrowing stock (often from index funds that hold them indefinitely), selling that stock and buying it back at a lower price, pocketing the difference as profit.
With disruption affecting every industry from energy to television it is often easier to pick the losers than the winners. Investors can profit from the inevitable decline of some industries as they are replaced by automation, substitution, or faster rivals. And to be certain, ‘disruption’ is merely a synonym for change, and change has been a part of business and industry since commerce commenced.
In the United States, Jim Chanos demonstrated the benefits of short-selling by being one of the first to question Enron’s accounting. Questioning the efficacy of accounts, the durability of business models, industry trends and fads, is the remit of investors who look deep beneath the lofty and optimistic forecasts that dominate the investment landscape.
A necessary counterweight
The existence of short sellers discourages earnings manipulation (they’ll be found out) and in a world where conflicts of interest can cast doubt on the independence of buy and hold recommendations, a band of researchers happily lifting the hood of companies to find flaws is a necessary counterweight.
For today’s investor, with share prices elevated, expected returns low, earnings growth challenged, and unsustainably low interest rates supporting lofty present values, the prospect of profiting from an inevitable decline in asset prices generally, and from the decline of some businesses specifically, is one that is difficult to ignore and shouldn’t be passed up.
My understanding is that ‘alternatives’ such as market neutral funds and long/short funds are reporting increasing inbound enquiry from planners and dealer groups and, with capacity generally constrained, it makes sense to understand whether such funds are right for your portfolio.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific circumstances of any individual.