Research Notes: A Short Sellers Paradise?
Fading the 'suddenly shaky' market rally seems wise — but it's not quite that simple.
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Since our first post at the end of March, we’ve leaned bearish on the market as a whole. Over the course of this month, after we focused on an insane day of trading on Aug. 5, we’ve been looking for ways to increase short exposure.
On Monday, we highlighted one potential trade: drone manufacturer AeroVironment (AVAV). AeroVironment’s history suggests the possibility of a big decline in a nervous market ahead of fiscal Q1 earnings. But it would seem like there should be many more such opportunities. This is a market that, to be blunt, has bid up a lot of garbage. Even for quality names, investors seem to have forgotten some of the lessons learned in the first few months of this year, let alone those imparted in, for example, 2007-2008.
But having spent a good deal of time looking for quality short ideas, the number of opportunities isn’t quite what it might seem. The ‘easy’ shorts are dangerous for a number of reasons. Bearish bets elsewhere in the market have their own problems. It shouldn’t be hard to find quality short ideas in this market — but it’s much more difficult than you might think.
The Rule Of 100
Two weeks ago, we updated our Shitco Rule of 100. The Rule of 100, a play on the SaaS Rule of 40, adds the inverse of one-year performance to short interest to create a not particularly scientific (but kind of fun) index of stocks in which shorts are most aggressively pressing already-winning bets.
Fundamentally, these types of stocks — to oversimplify, they’re pretty much all bad businesses — should be at risk of significant downside. That would appear particularly true at the moment given how those stocks have performed recently. When we published on Jun. 18, the top 8 stocks in our original Rule of 100 list had gained on average 73%. (Yes, seventy-three percent, not seven point three percent.) Yet the quality of the businesses was such that at the start of that rally, those stocks were down 85%-plus from their highs — and bears still saw significant further downside ahead.
Assuming this is a bear market rally (that’s a big assumption, yes, but it’s the one we’ll work off here), this group would seem to be a source of tempting short targets. And, indeed it was, as our post pretty much top-ticked the group:
source: YCharts. chart since 8/18/22
But the timing has to be just right. Again, these eight stocks had gained 73% over the previous month.
Fundamentally, there’s room to press shorts on these names. FuboTV (FUBO) looks like a zero. The business has not and probably cannot scale, at least not in time. Yet in the first half of this month it more than tripled in 11 trading sessions. (As we noted earlier this month, the rally actually was interrupted to the minute by the company’s Investor Day. A more perfect metaphor for the meme stock era we cannot conceive: the instant the fundamentals were even mentioned, demand for the stock dried up.)
Beyond Meat’s (BYND) 0% convertible (LOL) due 2027 is trading at 36, with a yield to maturity above 27%. It still has a market cap of $1.7 billion, and might well be a zero. But borrow costs are exceptionally high (as are option premiums), and the stock gained 22% after its earnings report this month, a report in which the company disclosed a negative gross margin.
We talked about Avaya (AVYA) last week, which seemed headed for bankruptcy, with debt priced below 20. (That article led to a fascinating Twitter exchange with Avaya’s newest major shareholder.) AVYA has nearly tripled in 23 sessions, and appears to be gaining a semblance of “meme” status.
There have been successes in the group, certainly. Scalping the goofy rise in Peloton Interactive (PTON) after its deal with Amazon.com (AMZN) certainly worked out. De-SPACs, which gained into the June peak, have weakened. Bed Bath & Beyond (BBBY) became a good short after the Ryan Cohen rug-pull.
There are more potential targets in this mold. Vertical farming plays like AppHarvest (APPH) and Local Bounti (LOCL) don’t appear viable. But each has a borrow rate ~30%, and the options market doesn’t provide a way around that problem due to spreads, premiums, and liquidity.
Nikola (NKLA) still is worth $2.4 billion, yet its long-term plan is in tatters. (Bear in mind that the point here was not for Nikola to be a manufacturer, but a vertically integrated supplier that could offer customers an end-to-end solution for hydrogen-fueled trucking. Raising $400 million through equity sales isn’t getting anywhere near that goal, which based on original plans would cost something like $25 billion.) But 30% of the float is sold short; why is NKLA not the next meme stock, or something close?
Elsewhere in EVs, Blink Charging (BLNK) and Volta (VLTA) still look badly overvalued in a competitive space with minimal differentiation. They, too, have cost of borrow issues. Workhorse Group (WKHS) and Lordstown Motors (RIDE) look like they could, and probably should, be zeroes.
There’s no shortage of options amid de-SPACs: Joby Aviation (JOBY) still is worth over $3 billion, and at least one of the other five (LOL again) publicly-traded eVTOL (electric vertical take-off and landing) stocks no doubt wipes out shareholders.
Most “Space stocks” aren’t going to make it. Skillz (SKLZ) probably is a zero. There’s simply a lot of garbage stocks on the public markets that still have market caps of $100 million or more.
In theory, these are all good shorts. But considerations regarding cost of borrow, options premium, and the risk of a surprising “short squeeze” all mean that the timing has to be just right. It’s not just risk from a ‘meme’ trade, either: both the breadth and the steepness of the recent move in speculative stocks prove there’s much more going on than just WallStreetBets.
Those considerations always exist from the short side, of course. But even in that context, since the beginning of last year it’s been scary to short a bad business in a crowded trade. Fundamentally, the trade may make perfect sense. Is that alone worth the stress of waking up in the morning five days a week terrified of finding out that the stock you shorted is up 35% premarket on no news?
For an investor who is
a simpering, sniveling coward making a judicious choice to avoid crowded shorts, the next step is to perhaps look at high valuations. This is a market that (sometime in 2021) realized paying 30x-plus revenue perhaps wasn’t such a good idea. But it’s a market that hasn’t completely learned that lesson.
A simple jog through the market shows a number of valuations that on their face seem ludicrous. EV plays Lucid Group (LCID) and Rivian Automotive (RIVN) have market caps of $25 billion and $29 billion, respectively, despite minimal production.
Airbnb (ABNB) trades at 52x this year’s consensus adjusted EPS estimate — but that of course excludes stock-based compensation. Account for that and the P/E multiple nears 100x for a business that has to be enjoying something close to peak demand and some degree of saturation worldwide.
Snowflake (SNOW) trades for 35x revenue. CrowdStrike (CRWD) is at nearly 20x based on FY23 (ending January) guidance. Zscaler (ZS) and MongoDB (MDB) are in the same ballpark.
Why is Uber (UBER) still worth $59 billion with no apparent ability to get close to actual profitability (we’re talking GAAP net profit, not Adjusted EBITDA)? Is Celsius Holdings (CELH) really the next Monster Energy (MNST)? At $8 billion-plus, it had better be. Is Dutch Bros (BROS) the next Starbucks (SBUX)? At more than 10x revenue, it needs to get close.
The problem here is that, to varying degrees, traders taking this path are shorting good businesses — or at least better businesses than in the first cohort we discussed. It does seem crazy that LCID has a $25 billion valuation — but by all accounts the company makes a ‘heckuva’ car. The expensive software plays are legit businesses. Shorts lost a lot of money during MNST’s long rise, and CELH could be a repeat. UBER and BROS have been “expensive” pretty much since they went public.
Some of these names have been good shorts of late, certainly. But we still have the same timing risk as with the more speculative names, and a real catalyst problem. LCID and RIVN are straight bets on market sentiment; they can be replicated elsewhere, presumably. It’s not clear what really shakes investor confidence in UBER or BROS. Valuation-driven shorts on SaaS on many occasions have been ‘widowmaker’ trades.
No doubt there are opportunities in this group, where valuations are a little too high or the business isn’t quite as good as what’s priced in. But this isn’t last year, where Roku (ROKU) was at $470 and Cloudflare (NET) above $200. At those levels, there was a margin of error from the short side. The margin of error is thinner now.
OK, Cyclicals Then
The next group would be cyclicals. We’ve targeted this group a few times, but shorts here also have some flaws.
In our bearish calls on boating stocks and on semicap Kulicke & Soffa (KLIC), we’ve chosen stocks that look ‘cheap’, at least from a headline perspective. Indeed, that’s usually the point of a cyclical short: that the current price is misleadingly cheap because profits are going to tumble.
The problem is that (at least to some degree) the market is pricing in a reversion to the mean. There are no doubt incremental opportunities in brick-and-mortar retail; I’ve heard smart people recommend shorts of Generac (GNRC) and Pool (POOL), both of which may still be significantly overearning. But the weaker cyclical businesses really have seen valuation compress, and the better cyclical ones (we’re looking at you, Home Depot (HD)) are, well, better.
As far as commodities (a traditional cyclical short)…what does the supply picture look like for oil? For copper? There’s Ukraine and OPEC and political uncertainty in Latin America and an insistence from producers that they won’t tank their own markets (this time). Being a commodity tourist is dangerous in a time of relative normalcy. Doing so now, with all due respect to current commodity tourists, is lunacy.
Certainly, an investor who is a big-time macro bear (and that’s a reasonable position to hold at the moment) should see plenty of opportunities in cyclical names. For those of us with less conviction about the overall economy, the risk/reward of betting against a still-resilient consumer seems more muted.
This seems like a market where an investor can be more bearish than usual toward the market as a whole — yet have less conviction toward individual shorts. The shorts that traditionally would be ‘easy’ following a peak — often stocks that are down 80% and have another 50-80% to go — seem more complicated than they were.
What’s left is the same kind of opportunities there are in most normal markets: stocks that are a little overpriced, businesses with intrinsic flaws or looming reversals, cyclical bets.
Those aren’t easy opportunities to find, let alone time. It seems like it should be easier now, particularly after the rally of late, but at least from this perspective it isn’t.
That’s one conclusion. The second is that (as we’ve also noted on this site) it’s not terribly easy to find long ideas, either. We’re not trying to complain. This does seem like an exceptionally difficult market.
Which brings us to our third conclusion:
At least we’re not alone.
As of this writing, Vince Martin is short KLIC.
Tickers mentioned: KLIC FUBO UBER CELH ABNB SNOW BYND PTON RIVN
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