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‘It’s never been a better environment to start shorting stocks’

It’s never been a better environment to start shorting stocks,” says Ray David, portfolio manager for the Schroder Australian Equity Long Short Fund. “The last decade has been about asset prices rising because of falling interest rates. We think that tailwind has now come to an end, particularly as Covid has changed market dynamics and inflation is becoming more persistent, even by central bank expectations.”

“We think stocks will trade closer to fundamentals and it’s quite a lucrative environment; all of a sudden, people are focusing on the earnings base of a company as opposed to buying on momentum and falling interest rates.”

By Schroders’ estimate, based on back testing of the market to 2002, in an average year, 40 per cent of stocks on the ASX fall, and 60 per cent rise. The team rules out “a significant number of opportunities because they aren’t investment grade from the long perspective”. The potential for shorting in that dynamic is massive.

The Schroder Australian Equity Long Short Fund is managed by David and Joseph Koh. Koh spent most of the 2000s at Schroders before a stint at one of Australia’s top hedge fund managers – “a good training ground for understanding the mentality of shorting and the risks around it”, and the lessons from which Schroders is looking to apply in the new fund.

“One thing I learned is that you do need to look at the upside, and that’s particularly the case for short selling; there’s always the risk that something goes positively rather than negatively.”

That’s particularly true at the moment, with a frenzy of takeover activity engulfing the market. Unlike long positions, the potential losses from a bad short bet are basically uncapped. To manage risk, the team looks at more than just valuation (which is a given), and hones in on specific dynamics at work in a company to determine what, when and how much to short. The team also reviews its position size and thesis when a stock moves materially against the fund.

Unlike the concentrated, high conviction portfolios common to hedge funds, the team maintains a large and diversified portfolio of around 40-60 long positions and up to 30 short positions, and direct stock coverage of the S&P/ASX300, as well as other eligible stocks. The other piece of the puzzle is a “red flags” system that Koh and David have designed to find companies with a penchant for aggressive accounting, acquisition-driven growth, and earnings revisions.

“It’s a way for us to flag which companies need further investigation and more scrutiny on the accounts and the policies they have in place, as well as management,” David says. “It doesn’t get away from us doing more manual work and fundamental analysis and talking to competitors and suppliers and the like.”

“The premise of the red flags tool is to put some science around when to short things, because we’ve found that the biggest driver of underperformance is poor free cash flow, negative earnings momentum, and earnings downgrades.”

But while there’re plenty of red flags to be found, there’s still the question of what you do with them.
While David and Koh are reluctant to talk in much detail about the shorts, they point to one company that was a major beneficiary of Covid-19, which David had covered extensively during his time as a sell-side analyst at UBS.

It was trading at 60 times earnings, making it the most expensive locally listed company in the global business, with a history of “lumpy cashflows” and a deep vulnerability to changes in consumer behaviour as a result of economic reopening. The short was on – then off again. The stock quickly broke through the team’s risk tolerance ceiling, but they continued to monitor the thesis behind it. The data started getting worse. App downloads, a key indicator for sales, nosedived. The short was back on – in time for a slew of bad news. The short has helped them generate “quite a bit of performance”.

“One of the things that Joe’s taught me from his hedge fund experience is that the market can stay irrational for longer than you can stay solvent,” David says. “It’s very difficult to short momentum, and the best time to short them is when they start to show evidence that the thesis around this momentum is unravelling.”

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