Every February the king of short selling, Jim Chanos, assembles an exclusive band of scheming cynics in the Florida sunshine to discuss what is likely to fall apart in the year ahead. He's dubbed his little gathering "Bears in Hibernation", in part to acknowledge his desire to escape the biting cold north-east winter but also as an admission that his kind aren't universally welcome in public places.
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It isn't easy being a bear – always looking to the downside, seeing half-empty glasses when everyone else wants to take a Panglossian world view.
For the past three years bears have been in hibernation for good reason. The pumping of money by central banks in the United States, United Kingdom, Europe and Japan into their stagnant economies has been a rising tide lifting all boats.
Investors have hardly bothered to distinguish between quality and rubbish. A search for yield triggered a stampede of borrowing at low cost and taking on ever higher risk. The price of assets has been bid up, from housing in London (up 18 per cent in the last year) and Sydney (up about 14 per cent) to US shares (up 14 per cent) to bonds and fine art.
As 2014 draws to an end so does an era of abundance for the US dollar – the world's reserve currency. America is finding its feet and the Fed is on the path to normality. The soothing words of "patience" from Fed governor Janet Yellen may have helped markets end on a high, but US rate hikes are inevitable and the days of cheap money will be over. Cracks are opening: China's property market is cooling; iron ore, coal and oil prices are plunging; investors in emerging markets and junk bonds are sweating as prices fall.
Sounds grim? Too depressing? It all depends on your perspective. If, after years of experimental loose monetary policy, the Day of Reckoning is drawing near, turn that frown upside down and forget investing in assets hoping they'll rise in value. Make like the bears and short them instead. "This is the best year for shorting since the financial crisis," says Atul Lele, a Bahamas-based chief investment officer for investment firm Deltec.
Opportunities for shorting
"With US dollar liquidity retreating it's going to open up a lot of short opportunities," he says.
Going long – investing in assets on the basis they'll increase in value – is straightforward. Going short – finding ways to profit from assets falling in value – often requires a little ingenuity, a little lateral thinking.
Two years ago, when Lele was a strategist at Credit Suisse, he was asked by clients to find the perfect way to bet on a slowdown in the Chinese economy. How do you short China? He scoured the world's tradeable securities, from New York-listed Chinese internet stocks to Japanese steelmakers, until his analysis revealed one definitive opportunity: a little company in Australia called Fortescue Metals Group.
It had one line of business – digging up iron ore. It had used significant debt capital to fund its expansion. It would be, Lele's analysis told him, Australia's "first loss piece" when China got a cold, the first investment tranche to get chewed up when our luck ran out. Jim Chanos and others already had the company in their sights and shorted Fortescue shares.
And 2014 was the year the Fortescue short came good. The stock has more than halved, following the 50 per cent drop in the price of iron ore. Bad news for company founder Andrew Forrest, good news for the bears.
The Aussie
One of the great shorts in 2014 has been the Australian dollar. For six months the currency – which has been a vestige for "carry traders" – remained in an eerily tight 3¢ range. Volatility was low, which made it cheap to short the currency in the options market. Reserve Bank governor Glenn Stevens said in a July speech that the market was "underestimating a significant fall in the dollar".
Only three months later the dollar began to plunge – breaking its narrow range before falling 12 per cent to trade below 82¢.
The Australian dollar is representative of two of the major forces in global finance that are reaching a turning point – the peak of the commodities super-cycle and the insatiable search for yield in a low-rate world awash with cash.
Mixed results for Australia
And for these reasons Australia has been a honey trap for the bears looking to make money from a slowing China. With an economy heavily dependent on Chinese demand for commodities, "overvalued" banks, a heated property market and a highly indebted household sector, it has all the hallmarks of an economy due for a calamitous correction.
But the foreign short sellers that are continually lured to the lucky country have had mixed fortunes. While Fortescue has threatened to fall to the floor several times over the past three years, each time it has surged back with a vengeance as the iron ore price has recovered or the firm has found debt financiers willing to back it.
Shorting the big four banks has been irresistible to many hedge funds convinced of an Australian housing bust and that the end of the world is nigh. But the bet has proven painful as property prices and banks' shares have held out.
Successful shorting, they have learnt, is about more than being a bear. It's about picking battles, being patient and managing the risk that investor exuberance will hang around longer than it should.
One of the analysts behind Chanos's bet against Fortescue is Andrew Macken. Macken, a young Australian and a graduate of Columbia University's famed MBA program, spent nearly four years in bear college at Chanos's Kynikos Associates before returning home recently to take a senior analyst role at value investor Roger Montgomery's firm at Ultimo.
Energy and resources
Macken was one of the architects behind Kynikos's successful short bets on coal and iron ore – identifying miners with a toxic mix of high production costs and weak balance sheets that made them especially vulnerable to falling prices.
Macken's current focus on finding good stocks in Australia to buy while helping the fund avoid landmines means he still has a keen eye for a short. While Montgomery is a long-only fund and takes no short positions, Macken says the energy and resource sector is still rich with opportunity for short sellers in the market.
The metrics are relatively simple: if the price of the commodity is below the cost of production, the company doesn't have a business. The juiciest shorts are the miners that have over-extended themselves and stretched their balance sheets. Here's a handy tip: Macken says funding costs such as interest expense should be added to cost per tonne calculations to assess its viability.
"Even if the underlying natural resource is money good that's not the main question – it's whether the asset can support the attached capital structure. It may ultimately need to reorganise itself and the equity will go to zero," Macken says.
Leverage
Financial leverage is really dangerous but it's a friend of the short seller.
"If a company is 80 per cent leveraged you only need a 10 per cent reduction in its assets to half the equity of the company," he says.
Macken sees no lack of short opportunities in the Australian sharemarket. Media is one – with the "free to air" sector looking particularly vulnerable.
"Consumers are happy to pay for content but not content they don't want. Consumer behaviour for content is changing. This generation refuses to watch adverts."
Retail
Retail is another sector facing a dual threat of disruption and a weakening economy. It has the attention of local and international short sellers and Macken agrees that some are worthy of betting against.
"It's a play on the deteriorating economy – national income is falling, tax revenues are declining and the consumer is weakening. Unemployment might not accelerate but it's still rising," he says.
The nature of bricks and mortar retailing, with a fixed-cost operating model, also means declining sales can place immediate and severe strain on a company's health particularly if it carries too much debt.
Short sellers have had a field day targeting the retail sector. The short interest in Myer is now almost 20 per cent of the shares, the highest level since its 2009 IPO.
While the retailers have suffered, the beauty of short selling is that it is never too late to pile in. Often when a stock pops upwards, hesitant bulls have missed the major move. When it comes to shorting, profits can be just as large for the latecomers. If a stock goes to zero, the short seller that got in at $30 makes the same 100 per cent return as the short seller that bet against it at $100.
A short position in Woolworths has been actively canvassed by the prime brokerage desks of the investment banks because it is being challenged by the likes of Aldi and Costco. They've been buoyed by the issues at UK retailer Tesco, which has overstated earnings to keep up appearances.
"The Woolworths of the world are being challenged by the discount retailers who reduce the profitability of the entire industry. The consumer wins but the industry shareholders do not," Macken says. But while he's far from bullish on Woolworths, he would be reluctant to short it given its dominant market position. It has the power to fend off threats at least in the short term. Woolworths has been a fruitful short – falling 20 per cent in six weeks from November 1 – but it could turn out to be a bear trap over the long run.
Business quality
Which brings us to the advanced class in shorting. The mistake many short sellers make is taking on solid companies because they believe them to be expensive, rather than fatally flawed. Shorters get badly burnt when values become richer.
"Never short on valuation alone – what is much more important is deteriorating business quality," Macken says.
That is the lesson learnt by several international hedge funds that have lost millions shorting the major Aussie banks. With high valuations compared with foreign banks, lofty property prices and an indebted household sector, the view from New York is one of imminent implosion. But as recent experience has proved, a bet against the big banks has been a losing one.
"They just don't make good shorts," Macken says. "They are high-quality businesses in an attractive and concentrated industry."
Lele says shorting the Australian banks is a good idea – just not yet. He's still in touch with bearish US hedge funds who got excited when bank stocks started to fall in October but urged caution.
"They are the single most highly leveraged – operationally and financially – investment in the Australian economy," Lele says.
"But, for Australian banks to decline, many other parts of the economy – and indeed the market – need to decline first, starting with commodity prices and mining capex, which has already happened, and eventually making its way to Australian banks," he says.
Housing market
What about shorting Australian housing – the source of the bearishness? Lele says he's often asked when Australia's property market is going to crack and while he's not ruling out that it might, he doesn't see anything imminent.
He tracks an array of global data points including Chinese "hot-money" flows. He says the most recent data is off the charts.
"Chinese hot-money outflows may continue to support the property market for longer than expected," he says. But should you want to take a bet against house prices a good tactic, according to Lele, could be shorting lenders' mortgage insurers that are "an extension of the banks' balance sheet" and would be the most vulnerable business to a weakness in property prices.
Lele, who has been bearish on iron ore for several months, says Chinese property will crack first. So how do you short Chinese housing?
'Why not short the derivative of it?" he says. A quarter of all steel production in China is used for residential property, which means a slowdown will place more pressure on the price of iron ore and its producers.
Emerging markets
Lele is most bearish on the prospects of emerging markets as tighter financial conditions and weaker energy and commodity prices place pressure on their economies.
He ran numbers on which economies are most vulnerable to a falling oil price and came to a surprising conclusion – it's a non-oil producing nation, Turkey, that could be smoked the most.
"We looked at things like deficits and foreign exchange reserves to see how long they could fund themselves – but also at their trading partners. One of the weakest economies is Turkey," he says.
Another potential short has been speculative "junk" rated companies that have been able to attract funding at low rates as investors have taken more risk to get a decent yield. In Australia, investors have gravitated towards equity-like hybrid securities, or in some instances over-the-counter bonds of unrated small cap companies.
For the most part these borrowers have been good for their money despite the risk – but the plunge in oil prices has exposed the risk in this trade.
"The high yield bond market funded the US fracking industry. The search for yield is intense in Australia but it's on crack in the US. There are almost certainly going to be credit losses," Macken says.
Local short sellers stay quiet
Seismic shifts are playing out in Australia's economy. The impact isn't obvious but there will be winners and losers.
That should open up more opportunities for short sellers who have already had a great run in Australia, though you wouldn't know it.
Local hedge fund short sellers differ from their international brethren in that short selling is taken a lot more personally here.
Famed US short sellers Chanos, David Einhorn and Bill Ackman take great pleasure in enthusiastically and actively sharing their short bets and the weakness of the companies they target. Here it is simply regarded as un-Australian to publicly denounce a company's business model, its prospects or even the market's collective wisdom in valuing its worth.
So they've tended to short in silence and with a great level of success.
Two of Australia's best-performing hedge funds in 2014, Regal and Auscap, both said their short positions were major contributors to overall performance.
But neither had any desire to discuss their specific short bets. Stock pickers are happy to say what they've already put their clients' money into.
Shorters keep their cards close to their chests. One of the most calamitous stocks of 2014 – Vocation, which plunged 93 per cent in six months – was discussed among a tight circle of hedge funds. Perpetual's long/short fund took a big short bet but without any US-style public fanfare.
Whether the silence of the short sellers is warranted or not is open for debate. Short sellers may be forced to live in the shadows but they perform a useful role in keeping markets efficient, countering the natural ramping up of investments by management, brokers and investors.
Australia's climate has proved favourable for short sellers – 2015 might just be the year they come out of hibernation.
