Shorting stocks is a divisive practice but one which can prove particularly fruitful in volatile markets, with a timely bet against a stock or a sector providing an alpha boost.
With long/short equity funds proving power performers in recent years – with the top three funds in the sector all breaching 100% returns on a three-year basis – investor interest remains strong.
While investors may be more than willing to shine a light on the standout stocks they have followed long term, getting fund managers to open their short books can prove a trickier task.
In this analysis, Citywire Global has canvassed three leading long/short equity investors to uncover short positions which has been particularly powerful drivers of performance.
Citywire A-rated Chris Kinder, who co-runs the Threadneedle UK Absolute Alpha fund, took a bet against UK estate agents Foxtons over the summer of 2014 as he believed the primarily London-based group was facing a rough road ahead.
‘At the time, we saw it was operating in a market with chronic oversupply and low barriers to entry, also the business model was vulnerable to disruption by technology,’ Kinder says. ‘Also, management departures and big holders were all selling at this time.
‘If you add to that the London property market was experiencing bubble-like characteristics. Furthermore, the stock was running at full valuation with peak multiple on peak earnings when we shorted it, and history shows how volatile the profitability of this business is.’
Citywire + rated manager Max Anderl, lead manager on the UBS Equity Opportunity Long Short fund, held a short position in oil tanker company Frontline, which he held for three years and bought back the position in 2014 following a drop of 90% in share value.
‘Enormous oversupply issues for the oil tanker industry ensued in 2011 as new ships, ordered before the global economic slowdown came to market. The extra supply depressed prices causing losses in the industry. We were under the impression it would take years for the market to restore this imbalance.
‘This oil tanker operator had aging ships and high fixed costs, putting it in a difficult position to compete. A weak balance sheet gave management little optionality to change this situation. Our scenario analysis showed high downside risk with limited upside potential even in the event of an industry recovery.’
Combining this with sustained and combined balance sheet difficulties, the European equity specialist believes selective stock-picking in the short book is what gives long/short equity the edge over its long-only peers.
In this field, Norris names oil rig operator and owner Seadrill as one of the best performing short bets in 2014. This, he said, was compounded by pouncing on what he called a ‘complacent bull market’ environment.
‘A year ago, even at $100/barrel crude, we had become convinced that there was now a glut of oil rigs compared to potential drilling opportunities and that this would put pressure on the price at which rig contracts were struck.
‘This would see long-term pressure on rig owner earnings and impair the cash-flows which were being used to service debt and pay generous dividends, which many equity investors had wrongly assumed were somehow cast in stone.’
Norris said the conflagration of OPEC announcing no plans to cut production and not meeting until the summer, he dived in and built up the short position against the oil and energy complex.
‘Oil companies reacted to the plummeting crude price by scaling back their drilling programmes and trying to renegotiate existing contracts,’ he said.
‘Rig rates had collapsed and even the revenues from previous contracts was now being questioned. Almost overnight assets turned to liabilities and the oil rig industry had gone from making super-normal profit margins to making no money at all.’
*The image used is classed as a 'generic' oil rig and is designed to reflect the oil sector, not Seadrill or the rig's operator directly.