Hedge funds, originally called “hedged funds”, had a very simple premise: find stocks to invest in, find stocks to bet against, and put money on both. If the market as a whole goes up or down, you should be sufficiently hedged against major losses, over time outperforming anyone who just went long an index fund.
Long/short has not been so successful since 2008, which has led to a lot of nasty criticism of hedge funds and major withdrawals from big hedge fund investors. Most recently, California pension fund Calpers pulled their investments from hedge funds, causing the space to lose about $40 billion in potential investments.
There are a few reasons why the hedging strategy is not doing so well these days. Partly, it’s because we’re in a bull market in which just about everything is going up, meaning shorts are hard to come by. Another problem is size; hedge funds are much larger than they ever were before, so they need to find larger companies to short. Bigger companies are usually big for a reason: they’re strong, they’re growing or well valued, and they’re unlikely to be fraudulent or unsustainable.
For this reason, some asset managers are looking for smaller, more promising hedge funds to allocate money to, which means long/short is still very much alive, and an important strategy to be comfortable with if you are starting out in the professional investing world.
How do you find short candidates? One famous shorter, Carson Block of Muddy Waters, looks for accounting fraud before targeting a company, and he has made some impressive calls in the past, with more controversial calls still unresolved as of today. Other value investment driven shorters, like Whitney Tilson, look for a variety of risks that threaten the company’s business model, relying on the thesis that an unsustainable business model will eventually collapse.
The First Step: Beta Analysis
The first step for any shorting strategy is to find highly volatile stocks that expose investors to more risk than the average company. Using a stock screener, you can identify stocks that are above a certain beta; for instance, as of today, there are 230 stocks with a beta of 2 or more. This can become your target list for shorting.
The Second Step: Due Diligence
Of course, a high beta isn’t enough for a stock to be a short candidate. Some stocks have high betas because they have extremely high risk/reward profiles, meaning that they are just as likely to skyrocket in value as they are to crater. The bigger question is which companies have less of a potential reward than the market expects, whether because of too much hype, a lack of focus, or complexities within its sector that the broader investor community is unaware of.
This means you need to know the company and its market fully and thoroughly before shorting it. Learning about it is the “due diligence” process that involves speaking to people in the industry, asking questions, getting feedback, and analyzing critically the commentary you receive. The difficulty with this step is that it isn’t all quantitative; balance sheets and income statements can show massive growth, but if the company relies on one product that is at considerable risk to disruption and the market is unaware of this, more informed investors can short it and make a healthy, risk-adjusted profit.
The Third Step: Is it Priced In?
Finally, analysts need to consider whether the risks they uncover are priced into a stock already or not. Just finding any risk factor for a high beta stock won’t do; the market knows about the risks in these stocks, which is why it is so volatile. However, there are sometimes additional risks that are even more severe than the market knows; these are the drivers that encourage an investor to short a risky stock.
When you uncover risk factors, you need to ask yourself: how well is this known? How many people are familiar with this risk? How much are they discounting the stock as a result? The answers to those questions should tell you whether the company is high risk, or too risky to hold at all.