My favorite screen, designed to identify under-the-radar small-caps with favorable investment characteristics, has recently picked some big losers despite having had a very favorable performance since I started tracking in April. I wrote about one, Ambassador’s Group (EPAX), last week. Bright Horizons Family Solutions (BFAM), Brush Engineering (BW) and Astec Industries (ASTE) have also suffered hits during earnings season. I always warn that screens are just a starting point and would also point out that the median return for the 15 stocks the screen generated at the end of September has been 4.25% (181bps above the R2000). The median return of the 22 stocks that the screen identified during Q2 (including ASTE and EPAX) has outperformed the R2000 by 218 bps.
When discussing these large underperformances with a client of mine, he asked whether perhaps my screen might be missing some parameter that might have avoided the disappointing stocks. I replied that one common element is a relatively high domestic exposure, which actually looks to be an issue for stocks in general. He asked me if they had particularly high or low levels of short-interest, to which I immediately replied that almost every stock the screen generates, despite having little sell-side coverage, has pretty high levels of short-interest. As I had been somewhat concerned previously that maybe the shorts knew something, which they do about ½ the time, I gave it some more thought. I think that I have the answer, but I am certainly curious if any readers have additional insight.
My hypothesis is that short interest levels have increased for small-cap stocks in general due to the burgeoning interest in 130/30 investing. I know that many of you are familiar with this white-hot trend, but for those who are unaware, this style of investing allows managers to increase their opportunity set by shorting unfavorable stocks and investing the proceeds in more favorable stocks. In other words, it is a well-defined hedge-fund style of investing (limits on long exposure of 130% of capital, limits on short exposure of 30% - hence 130/30). Like most things, it’s not really such a new idea as opposed to marketing of an existing idea. One big difference from what I can tell is that the strategy is being used by traditionally long-only managers. Pension & Investments reported recently that hedge-fund AUM growth continues to be quite strong (up 54% YTD), but the growth in 130/30 has been tenfold.
When I was working at a long-only firm, it killed me that there wasn’t a way for us to take advantage of our research that showed that a particular stock was a bad investment or inferior to a competitor. I used to joke in the early part of this decade about “pyrrhic victories” when a long selection would be down but would outperform its peers. Clearly, the idea of shorting against longs potentially raises returns and lowers overall market risk (if the manager is good). As I think about what has been going on in recent years, it is clear to me whether you call it official 130/30 (or other variants) or not, hedge-funds have increased their role in the institutional investing world. While they employ multiple strategies, many of them focus on small-caps. Why? Less research and investor focus and thinner liquidity offer the possibility of generating significant returns on good ideas. Also, many of these companies are pure-play, so an investor can buy or sell the stock in order to take advantage of a very specific driver without worrying about the idea being diluted by other parts of the company.
So, what does all of this have to do with short-interest? I believe that as capital has flowed to hedge-funds and to mutual funds or institutions that can engage in 130/30 or other strategies that allow shorting, the shorting goes disproportionately to smaller companies. What are the implications? Ultimately, this may actually be positive, as it could tend to smooth volatility over longer time-frames. While some may look at these larger short-interest levels and conclude that there is a ton of information or a potential exploitation, I tend to disagree. As we know, shorts are reported now on a bimonthly basis (in aggregate), while the longs of some (but not all) institutions are reported quarterly (by name). Unfortunately, we never get a really clear accounting of who all the players are and what the totals really are at any given time. Thinking about the 130/30 strategy specifically, it’s 130/30 not 100/30, and it is similar for a lot of the hedge funds that engage in long-short. There isn’t a net change in overall exposure to the market. Let me share a very simple example:
In this extremely simplified demonstration, assume that there are just two investment managers (A and B) that each manage $1 and there are only two stocks (ABC and DEF) that are each worth $1 at the time. At the same time, the investment managers change their guidelines to permit 130/30 investing. Firm A buys more ABC from DEF who shorts it, while Firm B buys more DEF from ABC who shorts it. Notice that the net amounts don’t change. The short-interest level, though, goes up dramatically (from zero to 30%).
So, I plan to be cautious regarding the levels of short-interest, recognizing that some of the shorts aren’t necessarily looking for a disaster but rather hedging their increased investment in stocks that they like. Traditionally, a large short-interest might have been more meaningful. Given that the investment managers in general have a tough time beating the market (sorry, but true), this commoditization of shorting makes it less meaningful. As I said before, the proliferation of these strategies should increase liquidity (and, thus, trading volume). So, perhaps more than ever, the number of days relative to the percentage of float becomes more meaningful. Even then, we all know that 89 days of any quarter, barring any significant news releases, don’t really matter as much as the other day (the day they report). I haven’t seen any calculations of short-interest relative to trading volume surrounding earnings releases, but that might be an even more precise way to think about it. At any rate, assuming that for every additional short there is an extra long, the responses to good news might be muted due to the “extra longs” taking profits and new 130/30 funds shorting at the higher level (and vice versa on bad news).
So, while my hypothesis regarding the proliferation of constrained shorting by traditionally long-only investors impacting the levels of short-interest for small-caps may make some sense, I am open to other ideas. An alternative regarding my aforementioned screen specifically is that there is simply a lot more money shorting, and the screen has a momentum element to it that perhaps is attracting practitioners of mean-reversion. Feel free to email me if you care to share your view.
Disclosure: Long ASTE (after the report!).