Short Selling Fallacies

I am big fan of Jim Chanos and other fundamental short sellers. They are the ultimate financial detectives who root out fraud, over-promotion and other excesses in the stock market. However, Chanos's recent interview paints short selling in too easy a light and does not truly refute the common risks associated with short selling.

We start with the well-known 100% profit limit on a short-sale of stock (borrowing and selling a stock, hoping to re-buy at a lower price). When you (short) sell a stock, you receive cash but also retain the obligation to buy that stock back. The profit on a full round-trip is therefore (the sale price minus the purchase price) times the number of shares. Because the sale price is set at the beginning, the lowest purchase price is 0, so the return on the original sale is  (sale price - 0)/sale price, or 100%.  

Chanos posits the ability for a short seller to sell more as a stock declines. On face, this doesn't seem to increase the position as a lower price means a lower market value on which to add. However, adding (selling more) does increase the obligation to return shares. If prices rebound after an additional short sale, the seller has both additional losses and a larger liability than before. Therefore, adding to short sales is risking more.

Secondly, Chanos discusses the unlimited possibility of loss given a short sale. He says that stop-losses and other automatic price triggers can reduce losses. This is also true for long positions, however. The key difference is that with short sales, one has to constantly monitor price and decide when/if to cover if there is an adverse move. Long and un-levered positions have the unique and key ability to wait, while shorts have to watch and are dependent on liquidity. In turbulent markets, this ability to wait is unparalleled:

(Source)

Would stop-losses help in the above? Perhaps a short seller can cover at the $300 level, but it is far from certain. Separately, what if the seller shorts more after the weakness in early October? He/she would have been serious trouble against a nearly 400% rally. Short selling can be profitable and in my opinion is highly useful to the economy at large. However, the real risks of this technique are Not easily overcome.

Alibaba and the Rule of "Law"

With the numerous articles about the upcoming Alibaba Group IPO, I'd like to focus on the rule of law and its history with the leadership at Alibaba (i.e. the Chief Executive Officer, Jack Ma). Alibaba may indeed be one of the largest and most profitable businesses in China, but does that translate to profits for investors?

For reference, Alibaba is one of the largest group of e-commerce businesses in China with over 7.5$ billion in sales in last year. Its multiple lines of business span across web portals for business to business transaction, payments services, Amazon-like search engines.  However, its focus remains in China, so why is it listing stock in the United States/New York Stock Exchange?

In short, it is because was denied listing in Hong Kong:

Alibaba considered listing its shares in Hong Kong. The company asked the Hong Kong Stock Exchange to allow a listing despite rules that permit only one shareholder vote per share; Alibaba has an unusual partnership structure that gives more sway to top executives, including Mr. Ma. After Hong Kong regulators refused to make an exception, Alibaba pursued a listing on the New York Stock Exchange, which allows more diverse ownership structures.

The "more diverse ownership" euphemism is essentially an admission that Alibaba did not want to give control with ownership and and went with the lowest denominator/least regulation. It will be using a dual-class like structure where founders' shares have more control than regular shares. Now, Google, Facebook and other internet companies have similar structures so that itself is not necessarily a damning factor. I personally believe is a huge incentive misalignment (it allows founders to risk other's capital without commensurate compensation). At worst, it allows founders to misappropriate assets without recourse (see below).

This is the least problematic of Alibaba's history with investors. When Jack Ma/Alibaba sold a large stake of itself to Yahoo, he had seller's remorse post-close and thought he undersold. He tried to buy shares back but since Yahoo refused he resorted to a transfer:

Mr. Ma transferred ownership of Alibaba’s fast-growing online payment service, Alipay, to an entity that he controlled. He didn’t get the permission of Alibaba’s board. He just went ahead and did it.

Basically, Jack did not like the terms of his sale and therefore ignored it. Yahoo/Alibaba did not get compensation for Jack's self-dealing and could do nothing about it. This is how Jack and the leadership at Alibaba treats investors that it does not get along with.

Furthermore, since Alibaba will be partially using variable-interest-entities as mandated by Chinese law, USA investors do not even own some parts of Alibaba. They have a profit participation interest via a Cayman Islands entity. Given that Jack and Alibaba's leadership do not even reside or do business in the USA, what potential recourse do investors/customers here have?

Suppose a year after the IPO Alibaba's shares have doubled, but the overall group's business is slowing down. What prevents the leadership from selling its stock, transferring the jewels of the business to themselves, and starting over?

Which Businesses can Consistently Make Money?

When buying businesses, whether in the public stock market or in private negotiated transactions, one key characteristic is the ability consistently make money. It is great if a company makes record profits one year  (for example $1/share), but what about the next?

Often, the companies and industries which are able to maintain and grow profits are the ones with durable competitive advantages. This is the "moat" that Warren Buffett refers to when he looks for companies to buy.

Example: a lemonade stand

Suppose that you are able to open a lemonade stand during the hot summer months. You buy some basic materials such as a chair, table, etc. and set up on the nearest street corner from your house. Business is good - you are able to buy lemonade in bulk from the grocery store @ say 2$/gallon and sell cups of lemonade so that the effective selling price/gallon is $4/gallon. Say you sell 1,000 gallons worth of lemonade each year so that your yearly pre-tax profit is: (4-2)*1000 = $2,000 or $2,000*(1-0.35) = $1,300 post tax.

Let's also hypothetically say it cost you $1,000 to set this business up and that you could hire someone for $300 to man the stand all year. Therefore, you could put down $1,000 and make $1,000 back in one year. A great return of 100% and full payback in a year! The is the equivalent of a 100% return on equity.

The Problem

However, next year your neighbor sees all the money you are making and decides to open an identical one himself for $1,000 and at same price point. Now, if customers only care about price you might make only $500 next year. More competitors enter until the $1,000/year reduces to almost zero. More specifically, more entrants will enter until the fantastic profits go away.

That is the nature of competition in capitalism and paradoxically is the worst for capitalists in highly competitive industries. We can see this happen in real-time with commodity or commoditized markets such as iron ore (e.g. CLF, VALE). In this case, a boom from China drove prices higher and led current incumbents in 2003 and 2008 to make record profits. This lead to increased capacity and new entrants over the next few years (the time it takes to increase capacity/enter the industry), which has led iron ore prices lower. Because iron ore is a globally traded commodity and is relatively easy to mine, it was sufficiently easy to buy another "lemonade stand".

A Solution

It is therefore the companies who can forestall competition which paradoxically benefit in capitalism. Newmarket Corporation (NEU) from my previous post may indeed be such a company because of product differentiation. NEU's customers are strongly tied to it and NEU's own 10-K focuses on the the adaptation of its own products to customer needs rather than pricing:

Competition

...

The competition among the participants in these industries is characterized by the need to provide customers with cost effective, technologically-capable products that meet or exceed industry specifications. The need to continually increase technology performance and lower cost through formulation technology and cost improvement programs is vital for success in this environment.

...

Most 10-K's competition focuses on price. NEU's does not. Instead, it is focused on service/technology. A competitor cannot easily build another NEU/"lemonade stand" because the products are highly engineered and customer specific - why would customers switch suppliers especially if cost is not the primary consideration? If a company is well-run and doesn't have to worry about price-cutting, perhaps it can survive, even flourish?