What a short seller looks for in a stock – and what to short now

Traditional funds and investment trusts tend to have most of their assets in equities. However, some "absolute return" funds take a different approach.

Some swap between shares and less risky assets such as bonds or cash, in an attempt to sidestep market downturns. Another approach is to take both long and short positions, so returns depend far more on the manager's skill at picking stocks than the performance of the market. One such fund is the Jupiter Absolute Return Fund, managed by Dr James Clunie, who agreed to talk with us about his strategy. As part of his doctorate in management from Edinburgh University, Clunie wrote a thesis on short selling.

"It is a good time to short the market", says Clunie, whose fund is currently net short (it has more short positions than long positions). Because short sellers tend to face high constraints on their activities, they tend to be smarter than the average investor, says Clunie. So following their behaviour can be a profitable strategy, at least in the short run.

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How to find a short-selling target

Clunie looks for companies with a high short interest (the number of short positions as a proportion of the total number of outstanding shares). He also likes shorting companies that have a seen a dramatic increase in the number of short positions.

However, if short interest in a company is limited, he may wait for others to make the first move. "In the past, when I've decided to go it alone on a short, we've invariably ended up losing money", he says.

He also looks for any negative catalyst that could alter people's perceptions of a company or wider sector. Internal events, such as directors leaving, firms missing their earning targets or breaches of loan covenants; or the CEO of a rival company saying industry-wide conditions are worse than expected something that could set him thinking about shorting competitors, too.

Short selling can be dangerous, of course. The potential losses are, theoretically, unlimited. But Clunie attributes his success to being willing to take losses, something many investors (on both the long and short sides) find difficult to do. However, while he always places a stop-loss on his trades his positions once they get above a certain price, he will tactically vary them to make sure other traders can't drive up the price in an attempt to get him to cover his positions. He will also close his positions if the facts change, such as the appearance of an unexpectedly positive piece of news.

What to short now...

Given Clunie's strategy of following other short-sellers, it should come as no surprise to learn that he is very bearish on the heavily shorted Tesla (NASDAQ: TSLA). Clunie accept that Elon Musk is correct that electric cars represent the future of motoring. However, he points out that there is no guarantee that Tesla will benefit from it as much as other investors think, "as there is already loads of competition". This is a big problem for investor since "Tesla's valuation is built on the assumption that it will be able to keep the market to itself". The electric car company also has taken on a lot of debt.

Another short-selling target that Clunie considers to be "really interesting" is American e-commerce firm Wayfair (NYSE:W) This company has seen its shares shoot up fourfold in the last eighteen months thanks to strong revenue growth. However, what investors are missing about this "glamour stock", according to Clunie, is that it has dismal financials. Indeed, its "balance sheet problems" are so critical that its liabilities are greater than its assets, giving it negative book value. Overall, given its negative cash flow, it's hard to see how it can service the huge amount of debt that is on its books.

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