A Conversation with a Short Seller

Short seller David Tice, new CIO of AdvisorShares Ranger Equity Bear ETF (HDGE), discusses short opportunities in a post-COVID world.

A short seller leads a lonely life, it seems.

Short sellers profit from stocks that decline in value. So, when they win, it means that most of their friends and family are likely losing. And when they lose? Well … they don't generally get a lot of sympathy. After all, they made money while the rest of us lost our shirts.

Suffice it to say, it takes a special type of person to hack it as a short seller. You have to have a contrarian mindset and exceptionally thick skin. And today, I had the pleasure of speaking with one of the all-time living greats in this space, David Tice.

David is a forensic accountant with a history of sniffing out fraud and overly aggressive accounting, and he previously managed the Prudent Bear Fund

In 2008, he exited the industry by selling his mutual fund business at the top (for short sellers!) just as the crisis was bottoming. Now, after more than a decade in hibernation and after a huge bull market run, David has decided to get back into the short selling business and recently became the Chief Investment Officer of the AdvisorShares Ranger Equity Bear ETF (HDGE).

With the major stock indices near all-time highs again, it might not hurt to get a professional bear's side of the story. David was gracious enough to share his thoughts. David, thanks for speaking with us today. First, let's hear what led you to get "back in the game"?

Tice: As a short seller, I sat out the entirety of the last bull market. It's been an artificial market juiced by low interest rates and share buybacks that boost earnings per share. Today, it looks an awful lot like prior bubbles that saw massive declines when they popped.

Now, with COVID-19 still out of control, it's a factor in separating companies that will be winners and losers going forward. There will be a change in habits. A change in lifestyle. Some companies will prosper. A lot will fall into oblivion.

I think this is the best opportunity I have seen on the short side in a couple of decades. What do you think the post-COVID investing world will look like?

Tice: The last 10 to 12 years have been driven by big inflows into index funds; more and more financial engineering, especially through buybacks; and artificially low interest rates. These were factors that inflated the "everything bubble."

Some of these conditions are still in place; interest rates won't be rising any time soon, for example. But buybacks face major political opposition these days and won't be as big of a factor going forward. And the tight correlations we've seen from the rise of indexing should start to break down as we get a separation of winners and losers in the market. The tide won't lift all boats.

Sure, the market has rallied sharply and many stocks have bounced hard. The worst-positioned companies have gone up the most in many cases. However, this will settle out.

Over time, COVID will certainly show which companies can survive and thrive and which emperors have no clothes.

That means you want to pick stocks, long and short, rather than just blindly dump your assets into an index fund and be done. Plenty of companies will fall by the wayside before this shake-out is over. This has happened following every bull market in the past. The creative destruction of capitalism creates winners and losers, and those losers become great prospects for us on the short side.

I think this fact will become evident over the next decade. If post-COVID, stock picking comes back into vogue, what advantages do you see for your strategy?

Tice: We are active managers. We don't just blindly short the indexes. This has a couple of big advantages.

First, if you short the index, you're shorting Apple (AAPL), (AMZN), Netflix (NFLX), Microsoft (MSFT) and the big companies that drive the market. Why would you want to short the best companies in the world? Does that make much sense?

Active management means we can short companies that have a variety of problems that expose them in market declines. In down markets, those stocks get creamed much more than the leaders. This is evident in how the fund does compared to the market in all 5% declines.

In addition, inverse funds don't work like people think. They don't actually track the indexes! Sometimes, they're off by a wide margin. It's a huge flaw in their structure.

Just look at what happened from the COVID decline and the recent rally. They underperformed on the way down and back on the way up. You didn't get the true "inverse" of the market return. You got something worse. Much worse if you used leverage. What do you look for in shorts for the portfolio?

Tice: I made my name as a forensic accountant sniffing out frauds and aggressive companies for several decades. And, one of the co-managers of HDGE is John Del Vecchio, who used to work for me. So, poor earnings quality is a key factor we look for. More and more companies are sticking their hand in the cookie jar to please Wall Street's short-term expectations. Long-term, this is a loser's game. It's like a mouse on a wheel.

Earnings quality is our bread and butter. We also look at poor quality of cash flows, inflated assets on the balance sheet, and companies under pressure from too much leverage. Care to provide a couple of examples?

Tice: Sure. Consider Snap-on Incorporated (SNA). The company has been pulling sales forward by offering generous financing. This may lead to aggressive revenue recognition, which would set the company up for a major earnings miss down the road. Stanley Black & Decker (SWK) is pushing into their market and will start using and expanding their credit to start to compete.

Camden Property Trust (CPT) is an office and apartment real estate investment trust (REIT). There's lots of exposure to Houston, which is getting slammed by retrenchment in the energy sector, and their assets are very poorly positioned going forward. There's a lot of oversupply of new space coming online in the next 12 to 24 months.

Canon (CAJ) is getting hit from all sides. Cameras and printers face major competitive risks from multiple angles, including higher-quality iPhone lenses and the rise of the green, paperless office. The stock is under a lot of pressure even as the market has rallied. The dividend yield is a trap. Buyer beware. As you mentioned, a lot of low-quality stocks have rallied hard recently. When the market settles a bit, how much downside do you think there is for marginal companies in this environment?

Tice: Well, I saw the 2000s tech bust coming. I saw the mortgage crisis in 2007 and 2008 coming. This will be much bigger than that. There's a huge disconnect between overall market valuations and reality.

So, there's probably never been a better time to get positioned to protect the gains you've made over the last decade. Valuations are stretched across the board.

The indexes might drop more than 50%. But that just means the largest stocks like Apple or Netflix fell 50% to 60%. The average stock – that company in the middle of the pack – could easily be subject to 75% to 90% declines.

It's going to be a whopper! That's why I am excited to join the team at The Ranger Equity Bear ETF.

The views expressed are those of the interviewee and not of Kiplinger's or its writers. Short selling is inherently risky as there is the potential to lose more than the value of your original investment. You should consult with your financial advisor before attempting to short sell stocks on your own.

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