How Firetrail insulates against macro investment risk
Short-selling has its fair share of critics, including high-profile Tesla CEO Elon Musk, who has garnered headlines for his notorious outbursts against short investors.
Short-selling has its fair share of critics, including high-profile Tesla CEO Elon Musk, who has garnered headlines for his notorious outbursts against short investors.
And for many, short-investing is a highwire strategy, but the asset management team at Sydney-based Australian equities fund manager, Firetrail Investments, has found a key role for it in the company’s absolute return strategy.
"We short anything between 80 and 150 stocks that we tip to underperform," says Firetrail's co-portfolio manager Patrick Hodgens.
Short investing is generally a transaction in which an investor sells borrowed securities in anticipation of a price decline; the seller is then required to return an equal number of shares at some point in the future.
"The strategy really is as simple as this,” Hodgens says. “The client invests $100, we invest $150 in the companies we believe will outperform - between 30 and 40 positions, high-conviction, fundamentally-research company.
"And on the short side, it's also $150 - we want to make sure long positions are equal to short, so net market exposure is zero."
Firetrail Investments launched in March 2018, after spinning out of Macquarie Investment Management, where Hodgens and co-portfolio manager James Miller ran high-performing funds for several years. They've now taken two of these strategies across to multi-affiliate investment manager Pinnacle.
Avoiding the macro threats
Hodgens explains shorting as a way of "insulating the portfolio away from things we can't control … because we don't know what's going to happen, from a macroeconomic standpoint."
A case in point, he cites the global financial crisis of 2008 and the major downturn that followed during which the ASX 200 fell about 50 per cent between July 2008 and September 2009.
"It took almost six years for the market to recover from that," Hodgens says.
The aim of Firetrail is to "insulate" its investors against such draw-downs: "If the market is down 20 per cent, that will not drive the alpha [above-benchmark returns] in this portfolio".
Fundamental stock selection, rather than themes, underpin its investment philosophy. It typically researches for about three months before adding a company to the portfolio, whether in a long or short position.
Shorting is different
"Short-investing requires a different mindset. We put valuation to one side, because it's not a great indicator in this context," says Miller.
"We look for catalysts. Just as share prices follow earnings, share prices also need a reason to decline," he says.
Examples here are company results announcements, such as half- and full-year reporting, and annual general meetings. If his team's research suggests a company is going miss market expectation on earnings, "it's a short opportunity".
Future earnings risk is another catalyst – such as a new competitor coming into the market, changes in company market share or the loss of substantial contracts.
He points to personal care and hygiene company Asaleo as an example on the short-side: "Once a catalyst occurs, it's important to close out that short position.”
Personal care and hygiene company Asaleo is one of its successful shorts
Not without risks
Hodges and Miller seldom hold short positions for more than 12 months, highlighting one of the reasons why short-selling isn't appropriate for all investors.
Crowded shorts – where a short-selling opportunity has become quite popular – is a key risk. Hodgens and Miller define a crowded short as one where more than 8 per cent of a company's stock is held by short-sellers.
"If you short one of those names, you need to have extremely high conviction that your thesis is right, because if you get it wrong, there can be a short squeeze very quickly," Miller says.
He cites the mining services sector in 2016 as a prominent recent example. "When the cycle turned, some of those names like Worley Parsons (ASX: WOR) and Monadelphous (ASX: MND) put on around 50 per cent [in share price valuation] in a matter of months. You've got to be very careful of crowded shorts."
Firetrail earns about 75 per cent of its alpha from long positions, and 25 per cent from short positions as a longer-term average. This figure fluctuates over shorter timeframes, with about 60 per cent of its returns generated from short positions since March 2018. "But that will average out to 70-25 [long versus short]," Miller says.
Miller says they are often asked if there are sufficient opportunities for shorting within the Australian market: "Even in really strong market years, there are,” he says.
In the year to June 2018, the ASX 300 index was up about 8 per cent, "but there were still 73 stocks that fell, in absolute terms".
"Every year, you will get stocks that fall, and you will have those catalyst-based shorting opportunities," he says.
On the flipside, crowded shorts can also be chance to take long positions. Hodgens and Miller cite Flight Centre (ASX: FLT) as an example.
"Around 20 per cent of investors held short positions. We used that as a buying opportunity," Miller says.
They had a strong conviction that company management had measures in place to turn around performance. "It was very cheap against its history … and to us it was an outstanding opportunity to go long,” Miller says.
"When they delivered, all those others [who were short] had to scramble to get out, so we got an extra 10 per cent kick on the share price.
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Glenn Freeman is senior editor, Morningstar Australia
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