The Big Short - The Need For An Externality In A Short

by: Varadharajan Ragunathan

“In the short run, the market is a voting machine. In the long run, it is a weighing machine,” said Warren Buffet.

However, what he did not say was how long the short run would last.

Given the froth in today’s markets and how “concept stocks” like Tesla (NASDAQ:TSLA), and Netflix (NASDAQ:NFLX) continue to scale new highs, it's an artificially created world of euphoria , (The Truman Show as Seth Klarman calls it), and it's easy to get burnt by short positions.

Again, as someone who is endlessly interested in the intersection of philosophy, physics and finance (read that as behavioral economics), I find it extraordinary how the market continues to vote for “talk” rather than the “walk” (i.e. valuations increase with announcements and the introduction of concepts/prototypes, no matter what the impact on cash flows):

  • The market is ultra-focused on one metric that it tracks – all else is irrelevant. For Amazon (NASDAQ:AMZN), it is revenue growth (no matter what the cost of the growth), for Netflix (it is the number of subscribers), for Tesla (the number of new cars).
  • The CEO is a visionary and has had past success – there is a “halo” bias. In fact, a previous study showed CEOs who look good, talk glibly and can speak the language analysts want to hear, tend to push stock prices higher (now, isn’t that obvious?)

This model has operating leverage because of,

  • The network effect
  • The creation of a strong brand
  • The marginal costs of servicing are ostensibly low no matter how high the cost of acquisition (how many SaaS companies that burn money to acquire customers are expected to become “cash flow” fountains once operating leverage kicks in?)
  • At one point, there's a serious threat that the company may "take over the world." Think of all the "high fliers" of yesteryear (Webvan at one time threatened to wipe out all retailers, AOL was touted as the company that would wipe out all media houses).

One of the bitter lessons I've learned from my experience with shorting “high momentum, high growth stocks“ is that they enter into what George Soros calls the “zone of reflexivity”, where new actions reinforce earlier actions resulting in a stock price that climbs higher and higher.

This results in one of the greatest paradoxes that you will see in the market – fundamentally-driven investors get burnt, then get out, only to see the stock finally fall.

Why does it happen?

While in the long run, a stock price is determined by fundamentals, on a day-to-day basis it is determined by transient supply and demand. As long as there is someone (“the greater fool theory”) to pay higher for the same piece of paper, the price climbs, and vice versa.

The wisdom of crowds - "crowds do not listen"

The trouble is that investors have a herd mentality (much like the Great Wildebeest migration) and it is easy for a lion or a tiger to get crushed by the sheer momentum. Modern day philosophy espouses something similar (see Charles Mackay’s book – Extraordinary popular delusions and madness of crowds).

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

So what’s the solution? How is the momentum broken?

No matter how tempting it is, I have learned never to short a stock unless I am sure the momentum is broken. Ironically, the answer might lie with technical analysis -- and a little bit of common sense.

External validation & discontinuities

Look at what happened with the recent Herbalife (NYSE:HLF) tug-of-war. Each point of discontinuity comes whenever there has been a material event that has led to a loss of momentum. If the FTC is investigating Herbalife, the stock falls 3-4%. If its has been cleared, it goes up 3-4%. Have the fundamentals changed ? Not in the least (as a corollary, I have found that it is easier to short a stock which has far more externalities than one that operates in a free market).

Cases in point

  • Regulatory interference: Herbalife – which operates in a regulated industry and comes under the purview of the FTC and the business model comes under the laws of the land
  • Quantitative externality: Allied Capital/Lehman – financial services companies intrinsically have many linkages that make it easier for the market to sense triggers that can break momentum. For example, an increase in cost of funds (which happened when markets froze in Sep ’08), the ability of market participants to independently verify the value of an investment (like David Einhorn did with the portfolio of Allied Capital).
  • Fraud/misconduct: Often, the most profitable shorts have resulted from fraud/misconduct. In most cases, frauds are the lids that keep the “blackbox” of secrets closed (because frauds by their very nature easy to establish). These are often the key points that trigger a reversal of momentum that allows for gravity to take over.

In summary, it might be worth it to:

  • Follow an activist investor who can expose a flaw – Einhorn in Allied/Lehman, Ackman in MBIA/Herbalife
  • Wait for break of momentum (material event that is bound to cause irreversible damage to the fundamentals – e.g. adverse preliminary findings from a FTC probe, margin calls/cost of funds going up for a financial institution)

...then jump in.

"Never ever short a stock solely based on valuation. The market can stay irrational for longer than you can stay solvent. Remember to use the crowd mentality to your advantage."

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