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In my job, I’m lucky enough to meet with thoughtful alternatives investors across different channels and countries. Interestingly, they often wrestle with similar dilemmas. While we don’t claim to have the answers to every question we hear on the road, this series will share the perspectives of some of Wellington’s many alternatives investment teams.
The devil is in the detail
Contrary to conventional wisdom, our approach to shorting often isn’t about anticipating macro events or predicting a company’s future growth rate, even in uncertain times such as these. Instead, we believe the opportunity is in the minutiae of three ESG-related issues: company governance, accounting and people (GAP). Digging deeply into the details can raise “red flags” that can potentially lead to substantial declines in stock prices.
Sorting the losers from the winners
In long-only funds, the ability to spot red flags — challenges to a company that suggest a high probability the stock may substantially de-rate — can help to mitigate risk within portfolios. In funds with the ability to short companies, the same skillset can be used to try and generate returns for investors. But where does one look to find those red flags?
We believe we can identify them by focusing on GAP issues:
- Governance — Is it lacking?
- Accounting — What does it reveal?
- People — Who are we dealing with?
We believe a red flag in any one area may signal a potentially profitable short position.
Governance: is it lacking?
Governance and culture can raise some glaring red flags. In particular, we look at the composition of the board, conflicts of interest and related party transactions.
We also check the backgrounds of all the directors and how the board operates, to see if it is truly independent. This can reveal some important conflicts of interest. Similarly, we look at the tenure and fees of the auditors. If their fees are high and the same auditor has been doing the accounts for a while, we would dig deeper to see if something is amiss.
Accounting: what does it reveal?
Close analysis of a company’s accounts can show that the reported results don’t reflect what’s really going on under the surface. Adjusted accounting has become something of an art form in recent years, with the increased use of a range of adjustments for “extraordinary” categories. Digging through these and truly understanding what they mean can throw up red flags that could portend a coming reversal. For example, a large beverage company reported top-line growth in 2018 of close to 10%. But we looked under the bonnet and found that this figure was almost entirely due to the impact of local inflation in their key emerging market rather than the result of real sales growth.
We also look out for a number of other red flags, such as unusual profitability, numerous questionable exceptional accounting items or policies and questionable acquisitions, among others.
People: who are we dealing with?
A look at the personalities who run a company can raise a red flag or at least prompt us to take an even closer look at its accounts and governance. In particular, larger-than-life CEOs — attention seekers who are constantly on magazine covers or are full of bluster in meetings and on investor calls — ring alarm bells for us.
Other warning signs we look for include undisclosed relationships and related-party transactions where family members, for example, do business with or otherwise interact with the company. On the relationship side, we scrutinise the company’s distribution partners and customers: who are they and what are their incentives and relationships?
We look for incentive structures that are set up mainly to enrich the CEO, rather than the company and its shareholders. Such structures often lead to extraordinary accounting practices intended to bolster the numbers artificially.
We also “follow the wrongdoers”, looking out for the use of accountants, lawyers and other suppliers that have previously been involved in questionable practices. The same names tend to crop up time and again. If a company is using one of them, we investigate in greater depth.
Red flags in practice
To see how red flags can help to predict an abrupt decline in a stock price, let’s take the example of a business process company. In this case, there was a sudden and unexplained departure of a long-standing high-profile CEO. This was followed by a series of acquisitions that were larger than any the company had previously undertaken. Looking more closely at the accounts, we calculated that operating cash flow had stopped growing, even as the accounts started to include more and more exceptional items. In fact, once the exceptional items were removed, cash flow was actually falling.
Shorting is a tricky business
Clearly, shorting companies demands caution and rigour. Doing it successfully also requires going beyond the conventional approaches of trying to bet on macro events or foretell a company’s future growth, which are notoriously difficult to get right.
But we believe that digging deeply into the details on ESG-related areas of governance, accounting and people can unearth structural challenges that may have a higher probability of predicating declining share prices and hence generating alpha for clients by using shorts.
Mind the GAP!
Talking Alternatives — Three ways to deal with “crazy” volatility (August 2019)
Talking Alternatives — Opportunities in late-stage growth (January 2020)
- Equity market
- Long-short strategy
- Short selling