Hello reader, welcome to the latest issue of HX Weekly!

Each week we bring you a new edition of HX Weekly that includes three distinct sections.

In the first section, Thoughts on the Market, we'll offer insights into current economic and market news or timeless insights.

In the second section, HX Daily Redux, we'll revisit investing concepts, tactics, and more from past issues of HX Daily.

And in the third section, Market Wizard’s Wisdom, we’ll share thoughts, quotes, and theories from the greatest investing minds of all time.

Now, let's dive in!

Thoughts on the Market

Lessons From the Hedge Fund Pioneer

Earlier this week, we celebrated the birthday of hedge fund pioneer A.W. Jones.

Most of you are not familiar with Jones but he was an investor who essentially “invented” the first hedge fund. He is credited with creating the first hedge fund structure in 1949.

Later in this note we tell his story, but we want to talk about his “invention” and how it can help you improve YOUR trading and investing.

There is a SINGLE INSTRUMENT you can use to harness BOTH powers of his model.

We are going to tell you about it…

The “hedge” in Jones’s invention is his idea that he could use short selling to avoid (or mitigate) market risk.

We won’t go through the mechanics of how short selling is done, but it is a way for you to make money when a stock goes down.

The classic (and WAY over simplistic) theory of a hedge fund is that you buy good companies at good prices and short bad ones at bad prices.

Then when the market goes down, you are protected on your good companies as they all trade together. Through time, though, you make the “spread” as the good ones outperform the “bad” ones.

There is nothing wrong with this theory, but it brings up my favorite Warren Buffett saying, “Investing is simple, but not easy.”

The other, and lesser known, part of Jones’s strategy was using “leverage” to buy more shares.

We don’t want to get to far into the weeds, but Jones was able to use the cash he sold from selling the shares “short” to buy more stock.

This meant that if he had a $100 portfolio, he could afford to buy more than $100 of stock.

Again, it is complicated how you can sell something you don’t own and get the cash for it, but it works.

In this $100 portfolio example, Jones would typically sell “short” $40 worth of stock. This would leave him with $140 of cash.

He then would buy $110 of stock long.

At the end he would own $110 worth of stocks he liked, be short $40 worth of stocks he disliked and his “exposure” to the market would be only $70. This is calculated by subtracting the shorts from the longs.

Also, note that he has a total of $150 worth of bets on the table. Those are bets that can both go right or wrong.

If he is right, this structure should produce greater returns (the leverage) while seeing lower risk (the hedge).

In fact, this IS what happened for him and the many others that followed his model over the next 75 years.

In this note, we are not going to get further into the weeds on the nuances of this structure. As Buffett said, it is not easy.

We do have a way, however, that YOU can replicate some of these advantages in your portfolio, without taking the risk of the leverage (yet getting some of the benefit) nor having to take the unlimited risk of short selling.

What is that method?

PUT OPTIONS.

A put option is the right, but not the obligation to sell a stock at a specific price by a specific date.

For instance, you could buy the NVIDIA Corporation (NVDA) $200 put options that expire on March 19, 2027, earlier this week for roughly $13 a contract.

That contract allows you to SELL 100 shares of NVDA for $200 per share.

Well, with the stock trading today at roughly $220 per share, it isn’t a very good deal!

The difference between the stock price and the specific price you can buy it at (strike price) is called the “intrinsic value.” In this case it is negative $20.

Why would we buy something for $13 when it is worth -$20?

The reason is that a lot can change between now and March.

It is not an exact analogy but put options can be viewed like insurance. You buy a policy out for a year, and it will pay off a lot if certain events happen. If they don’t, you lose all your money, but if they do, you get a big payday.

Again, we are not going to go through all the details here but how can you use put options to replicate parts of Jones’s strategy?

The first part is clear – when you buy a put option, you can benefit when a stock goes down. Just like short selling.

They also come with one big advantage.

When you sell a stock short, the stock could go up infinitely in theory. This means your potential loss is unlimited.

When you buy a put option, the only money you can lose is the money you paid for the put.

This way you can CAP your losses.

There are trade-offs. When you are short a stock, you don’t lose money over time if it does nothing.

With a put option, you will lose the “time premium” in the option.

This is where the other advantage of options play a role.

Options inherently have considerable leverage.

Take an example where NVDA stock trades from the current $220 to $150 per share. Yes, that seems impossible, but when the bubble bursts, it likely will trade even below that level.

On your short position you would make $70, or a +32% return on your $220 of capital at risk.

The $200 put option would allow you to make a $37 profit. This is the difference between the $200 you sell the stock at (the strike) and the $150 you could buy it back in the open market. That is $50, and then you subtract out the $13 cost of the option.

This is a +185% return!

The $38 is divided by the $13 cost.

Here is the advantage…to protect your portfolio you need to deploy a far lower amount of capital than you do with a stock.

It has higher risk, but when done right this can be a powerful tool.

There is a lot of nuances here but we wanted to introduce the concept to you all.

Jones never had the opportunity to use this strategy. Put options didn’t even exist!

Want to know another one of your advantages?

Most big money managers ALSO cannot use this strategy. They are simply too big and manage too much money.

We encourage you to do some reading (including in our archive) on options and see how you can take A.W. Jones insight from 75 years ago and harness it for your own gains today!

Short selling can be a powerful tool for your portfolio, but like any powerful tool, it can also be very dangerous.

Here are our thoughts on the single most important rule when looking for shorts on an ongoing basis. This metric can also save you a lot of money in your long positions!

HX Weekly Redux

The Key to Short Selling - One Metric to Rule Them All

Today, we are going to talk about the key to short selling.

Some investors have negative views of short sellers and short selling. We agree that sometimes short sellers act improperly, but overall, they serve a vital role in the stock market.

They help uncover dangerous situations in which investors—retail or institutional—may be deceived, and they end up saving folks a lot of money.

These “fraud” type of shorts, though, are only a small percentage of stocks that go down.

Remember, the goal of short selling is not to uncover and disclose a company's nefarious action but rather to profit from the stock's falling share price.

The internet barely began when we began our careers in the 1990s. There was no such thing as a “PDF,” and we still read many research reports in physical form.

There were many more "fraud" shorts back then because the dissemination of information was much more limited.

The world is MUCH different today.

Listen to our recent podcast with value investor and activist short seller Gabriel Grego, and you can hear more on this topic. You can listen to it here or watch it here.

As a result of these changes in market structure, many investors have argued that short selling is dead. We have heard this said a lot.

It is also one of the dumbest statements out there.

As we said above, short selling aims to find stocks that go DOWN. It is NOT to uncover frauds or prove yourself right.

Saying short selling is dead is the same as saying stocks will never go down again.

We know that there will ALWAYS be stocks that go down. The key to short selling is finding these stocks.

This brings us to one of our core views on investing: Look for earnings growth and revisions to understand the path of stock prices.

Now, "growth" doesn't just mean positive growth but can also mean declines.

If you can find stocks with earnings going down – on an absolute basis and analyst revisions – then you will find some good (or great) shorts.

We thought of this recently when we were listening to CNBC, and they talked about discount retailer Five Below, Inc. (NASDAQ: FIVE).

This stock has been an awesome winner in the last few years but has recently been hit hard. Here is the chart of the stock price over the last five years…

You can see that from the summer of 2022 through the middle of last year, the stock had a nice run, trading from $115 a share to more than $200 per share. It was around those levels even just a few months ago.

Then the stock cratered! What happened?

Look at this chart of earnings revisions…

A couple of years ago, the company was expected to earn almost $9 per share in this fiscal year. However, that number is now below $5 per share.

The precipitous drop in the stock coincides strongly with the slide in earnings revisions. THIS is why the stock is going down.

Now you could look at this chart and ask – why didn’t the stock go down when the earnings revisions were coming down back in 2022 and early 2023?

There are several answers to that question. In 2022, there was a perception that they were working off the post-COVID hangover of binge buying. Then, in 2023, the revisions were negative but not THAT bad.

One thing is for sure, though a SMART long investor would not have wanted to own this stock.

Why own a stock with negative earnings revisions when so many have positive revisions?

A savvy short seller also would have become interested. The stock rallied and then trod water as earnings estimates ground lower. THIS was a nice risk/reward as a short seller and precisely the kind of stock you want to be looking to identify.

Short selling is not dead, but you must know what to look for in a successful short.

Find a company with negative earnings revisions, and you will have a good start!

In honor of A.W. Jones’s 126th Birthday, we are sharing a note we wrote about him several years ago. Enjoy!

Market Wizard’s Wisdom

The Story of the FIRST Hedge Fund

Our readers are a mixture of a broad spectrum of investors.

Some of you are experienced money managers who manage (or have managed) billions of dollars, while others are just beginning their investing and trading careers.

At HX Research, we try to write our publications in a way that is educational and informative for all readers.

No matter where you are on the spectrum, we are sure you have heard the term "hedge fund."

The term initially referred to funds that could use a variety of instruments to help "hedge" their investments. This means they might try to remove some of the risk from their portfolio by using other securities.

Today, the term has expanded to refer to many different types of funds that employ many strategies. For the most part, it simply refers to funds that have flexible strategies.

Do you know the story of the FIRST hedge fund?

That fund was established in 1949 by Alfred Winslow Jones or A.W. Jones.

After graduating from Harvard and Columbia and serving as an editor at Fortune magazine, Jones became convinced that he could do as well as the professional investors he wrote about. He established his fund with initial capital of $100,000, including $40,000 of his own money.

Jones decided to do something entirely different from his contemporaries when establishing this fund.

In his strategy, he decided that his fund would also go “short” stocks. This would allow him to take advantage of share price declines.

It would also allow him to be “hedged” and remove some stock market risks from his portfolio. That would allow him to focus on the specific idea that he owned and not have to worry as much about the market.

This all sounds very ordinary today, but back then, it was revolutionary.

While short-selling strategies were associated with some speculation (and stock manipulation), respectable professional investors did NOT employ them.

The view was that a short was too risky a strategy because there was an infinite risk to the downside (a stock could go up an unlimited amount).

Jones had the novel idea that if stocks were shorted intelligently and in a diversified manner, he could REDUCE the risk of his strategy.

Jones also revolutionized several other concepts. He began to examine a stock's volatility to understand how it might impact his portfolio. He called this “velocity,” and his staff charted it by hand.

He also began to look at how a stock traded relative to the overall stock market. He called this relationship the “relative velocity.”  We now call it the “beta” of the stock relative to the stock market.

There were many other innovations beyond these.

He understood that having information before other investors could be an advantage. He would have his staff physically go to the offices of the Securities and Exchange Commission (SEC) to read new filings right as they were released.

As a private partnership, he pioneered a novel fee structure. He structured his fund so that it avoided the Investment Company Act of 1940, which allowed him to be paid out of his profits.

This structure more closely aligned the manager's success with that of his clients. It was also relatively expensive for investors, but it attracted the best and brightest to the strategy.

By thinking independently, Jones could utilize strategies that gave him an advantage over his competitors. In doing so, he established a tremendous track record. A $10,000 investment in his fund at its inception in 1949 was worth $480,000 two decades later. He lost money in only three of his thirty-four years managing money.

After thirty-five years of managing money, Jones turned his fund into a "fund of funds.”  This is a structure where instead of investing directly into stocks and other assets, they invest in other hedge funds.

I am proud to say that his fund invested in several of my hedge funds over the years.

You may not be familiar with A.W. Jones, but his novel approach helped change the face of investing and created a trillion-dollar industry.

We hope that you’ve enjoyed this week’s issue of HX Weekly…

Do you have any thoughts, questions, or feedback? Tell us more in the comment section or at [email protected].