When did you last read a research report that said “Buy, because the accounts are really clean and governance is text book?” Great Longs are not the opposite of great Shorts, where for example a really strong governance point can on its own be an unacceptable risk and drive underperformance. So, why do we believe the shorting skillset makes our Long analysis better?
Refining classifications
Looking for high-conviction Longs is different from classic buy and hold investing. Our classifications for Longs – “value + catalyst”, “structural growth”, “fallen angels” and “cyclical Longs” each require a refined skillset. So, for example, “value + catalyst” requires the ability to assess the intrinsic value of often a troubled business while also identifying the journey necessary for that value to be catalysed.
For cyclical Shorts we study the level of return and valuation, along with the supply of capital in cyclical businesses. This is not the same as taking a top-down macro view – there are many industries that have their own cycles. For cyclical buys we look to situations where capital has been withdrawn, returns on capital are low but valuation discounts this as being the new normal.
There’s a fine balance between “good” and “too good to be true”
Working on Shorts develops our analysts’ pattern recognition for overhype and promotional activity. Amazing topline growth doesn’t look so good if working capital is ballooning. Huge TAM doesn’t look so good if new entrants are crowding.
To find skeletons, you have to look in the cupboard
We routinely look into the accounting and governance of our Longs, aiming to make sure they do not raise red flags. We are naturally predisposed to look for risk indicators and sceptical when things start to look too good to be true.
Some of the best Longs start as Shorts
Contrarian value is yesterday’s Short. Except, it takes skill and practice to call that a distressed name undervalues the option of survival or a governance situation that is turning around. We do focus on distressed names and focus on the skillset to understand capital structure and cash flow.
Understand your enemy
Only by understanding a bull case can you really have confidence in the Short case materialising. Conversely for the Long case to come through, you need to be confident there isn’t a good Short case.
Inflating bubbles
We have to acknowledge that a sceptical mindset tends to spot and avoid bubbles. An inflating bubble is a powerful, if risky, driver to Long performance. Short analysts tend to be too cautious here, but looking for Longs can also help stop us being too early on the Short.
We look at the overwhelmingly positive skew of bulge-bracket recommendations and question whether analysts are just not accustomed to looking for the negatives.
Overall we find the need for our analysts to generate both Long and Short recommendations leads to better recommendations on both sides.
