An Important Strategy for Your Investing 'Tool Kit'

We shared the famed hedge fund Tiger Management's Investment Framework in yesterday's HX Daily.

While the firm made most of its money going long on stocks, one fascinating aspect of the Tiger process is that these folks spent most of their time looking at shorts.

So, if one of the most famous investment firms in history spent the majority of its time working on shorts, should you?

First, keep in mind that while selling stocks short can be rewarding financially, mathematically, shorts can never be better than longs. The most you can make on a short is 100% of your capital deployed. A stock can only go to zero. You can make 200%, 500%, 1,000%, or even more on a long investment. This is just math, meaning longs should always be the primary focus of your investing, especially if your goal is to make money.

Additionally, shorts are riskier. On a long, you can only lose 100% of your capital. With a short, you could lose the same 200%, 500%, or 1,000% the other way. This is what we call a "bad risk/reward."

And finally, remember that the incentive framework is stacked against you when you go short a stock. Company management and shareholders are all working to make the company a success. This means many highly motivated people are actively working to lose you money. This doesn't mean they will be correct, but it's essential to consider the incentives.

So why did Tiger spend so much time on shorts?

Fundamentally, Tiger was a hedge fund – the idea was that it could take out a lot of the overall stock market risk by having good shorts that would offset any market volatility.

And being hedged – in theory – makes you a better long investor. If the stock market goes down 10% on a political event and sends all your long positions lower, but you don't lose much of your money overall because of your hedges, you're unlikely to sell under pressure. In fact, you're more likely to make the right move, buy more of your longs, and cover some of your shorts.

Proper hedging – and good short sells are a great way to do it – can be a powerful investing tool to improve your results.

Additionally, the process of being a short seller makes you a better long investor.

Given the risks of short selling that I explained earlier, it's critical that you do even more work on a short than on a long.

Throughout my years in the markers, this is why I often spent as much as 70% of our time on the short side, even if longs made up 90% of the returns.

Understanding what makes a stock go down (and what makes a company disappoint the market) is a great way to "check" your work on the long side. It's one of the reasons I have been able to avoid many of the most frustrating positions, such as "value traps."

If you start doing the work on a long, but it begins to sound like a great short, it's time to move on.

With this in mind, I'll share the Tiger Investment Framework for shorting.

While incorporating shorts (or hedges) into your investment portfolio needs to be done thoughtfully and carefully, incorporating the short-selling process into your investment process is a no-brainer...

Investment Framework: Shorting

Is this a bad business?

• Who has the power – customers, suppliers, or competitors?

• What are the barriers to entry?

• What kind of reinvestment of capital is needed to grow?

• How is the business changing?

• What is the historical and current rate of success in this business?

• What are the major risks to the business plan?

What is the major misperception?

• Why does it exist?

• Who is responsible for it?

• What stakes do the various parties have in keeping the stock price high?

• How popular is the industry? A rising tides lift all boats... for a while.

Assess management

• What's the industry reputation?

• Look at past history of success or failure.

• Is management straightforward or cunning?

• Check out insider ownership and selling.

Ratios

• Earnings before interest and taxes ("EBIT") to enterprise value ("EV")

• Earnings before interest, taxes, depreciation, and amortization ("EBITDA") minus capital expenditures ("capex") to EV

• Growth of inventories to cost of goods sold – are inventories rising faster?

• Growth of accounts receivable ("AR") to sales and accounts payable ("AP") to sales

• Any accounting changes – a smaller reserve for bad debt, revenue recognition, etc.

• Cash flow to interest expense

• Review Howard Schilit's red flags. [He's a pioneer in the field of detecting accounting tricks... Last week, I mentioned his book Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.]

Sentiment: Are more people bullish or bearish on the stock?

• Do a full media search for articles. Make a list of analyst recommendations.

• Short interest? (Remember, the stock that is already short is potential buying power.) Be careful if there is universal bearishness.

Timing

• What is the expected trigger on the misperception? Make a timeline.

• Who owns the stock – long-term or short-term investors, momentum investors?

• Has the soufflé already risen once? [In other words, has the stock seen a significant move higher?]

• Can the rising stock price be self-fulfilling for a while (financing opportunities, etc.)?

• Where does the company stand regarding the fantasy, transition, reality paradigm?

And when the story starts to unfold – regardless of stock price:

• Watch for earnings warnings, excuses, etc. Where there's smoke, there is often fire.

• Is the company or Wall Street analyst group in denial of the problem?

• Watch the ratios, insider selling, etc.

• Even if the stock is down significantly from its high, if answering all these questions convinces you that it is still a short, do not cover and consider adding to the position (see below).

• Does waiting for the new financials feel like waiting for Christmas? If yes, add to the position.

Again, even if you aren't shorting stocks, it makes sense to consider the points from this Investment Framework and utilize them in your own process. Here at HX Research, I incorporate questions like these into the research process.