US Videos

How to Succeed in Short Selling

Josh Charney, CFA

Josh Charney: Hi, my name is Josh Charney. I'm an alternatives analyst here at Morningstar. Joining me today is one of the Alternatives Fund Manager of the Year recipients, Ali Motamed from Boston Partners. Ali, thank you for joining me today.

Ali Motamed: Thank you for having us, and it's a real honor for our team to win this award.

Charney: Sure. So, looking at some of your fund statistics, the fund was in the top 5% for alpha generation for the long-short equity category. It was up 4.72%, which means it beat the category by 1.8%. Boston Partners Long/Short Equity (BPLSX) is one of the oldest funds in the category. It was incepted in 1998. It has the best 10-year returns and has had extremely good alpha generation since 2008. So, Ali, now that you're here with us today, can you tell us a little bit about the fund and what it does?

Motamed: Sure. We manage a variable long-short product. It's very diversified, mostly focused on the United States. Most of the time, we are fully invested on the long side and then we have a goal of absolute returns on our short portfolio, which is what leads to the variability in that. So, that portfolio has been as small as 9% of the fund and as high as 80% or 90%. And that leads to our net long positions that have varied from 90% to as low as 20%.

Charney: So, I understand the fund is very fundamentally bottom-up driven. Can you go into a little bit about that process and what it is that your team does on a daily basis?

Motamed: Sure. Everything we do is on a bottom-up level on stock-picking. We go through financial statements of up to 7,000 companies that fit our universe, which is a $100 million market cap or more in the United States. And we're trying to find longs that meet our investment criteria and shorts that we think will drive absolute returns and also meet our investment criteria. And so, as we look at that investment criteria, on the long side, we're looking for fundamentally good businesses that are at good values where things are basically getting better. And on the short side, generally we're looking for companies that have deteriorating fundamentals or are story stocks or have periods of unusual profitability where they are getting big multiples and credit as if that will continue in perpetuity, but the dynamics of the industry that they are in suggest it won't.

Read Full Transcript

Charney: So, we've seen at Morningstar quite a few long-short equity funds sort of flop on the short side. It is definitely very easy to get squeezed on the short. It's easy to make the wrong calls in both the sector as well as the fundamental name. So, what is it that your team does differently on the short side?

Motamed: I think the most important thing on the short side is diversification. Generally, in these names, it's hard to predict timing sometimes. The fact that they are short and we think that something may be irrational--it's very hard to find an end to irrationality sometimes. And so, by staying very well diversified in running in excess of 150 names on that side, no one name can individually hurt us. So, even though we do have names that may go up a couple hundred percent, it doesn't destroy the performance of our aggregate portfolio.

Charney: But there's definitely a trend on the short side; maybe it is extremely diversified, but there are some singular attribute you guys look for, such as concept stocks--as your team likes to refer to them--or like tech stocks, such as Twitter (TWTR) or Netflix (NFLX). Can you talk a little bit about some of the dynamics of the companies you look for to short and maybe some of the shorts that have worked well in 2014?

Motamed: So, generally, there are three types. The first type will be deteriorating businesses. These are businesses where the fundamentals of the business are struggling and they are going to continue getting worse. The earnings profile is going to deteriorate over time, and the multiple will theoretically collapse. The other side of it will be those bubble stocks where earnings are going through, I guess you could define it as, a pig-through-a-python type of period. And when that's done, it's going to disappear, and then that earnings base is going to go down. The third type--and the type that we are probably a little more invested in on the short side now--is these story stocks, as you mentioned.

And generally, they are companies that don't have free cash flow, and we have a very difficult time imagining them generating enough free cash flow to justify massive market caps. And we diversify very, very heavily among that group and try to find businesses where we think the investor sentiment is way out of reach. And when you look at those stocks, often what happens is that things go OK while they're working, but when they start failing, there is just this massive gap between where a fundamental value investor will step into that stock and where that story has broken. The story no longer carries itself. And so, we diversify ourselves among that group and have driven great returns on that, too.

Charney: So, let's go into a few names specifically on the short side--as well as on the long side, if you'd like--that worked in 2014. So, on the short side, the fund was short Netflix and names like 3D Systems (DDD). What was the rationale behind some of those names?

Motamed: Generally, we don't like to talk too much about individual short stocks, but I think one common [thread is that] those would be defined as story stocks to some extent. One commonality they have is that they don't generate much free cash flow. So, as long as the story is going, it's great. But the minute that story stops, there is--like I said--a huge vacuum. And in many cases, there are a lot of competitive threats. I can count six or seven public 3-D printer companies. There are a lot of distributors of content out there. And so, like I said, we don't mention each individual stock specifically, but those will be the themes. And free cash flow, I think, on these story stocks is a big deal.

Charney: And then in terms of the risk-management process--because on any given day, definitely, some of these names can pop and do well--what is it? Is it diversification? Is it size limits? How does the fund stop from getting whacked by some of these names?

Motamed: It's both of those. It's definitely diversification and size limit. Sometimes, you may initiate a small short and even if it goes at a 30-basis-point position and it moves in multiples, it gets too big and we have to manage the size at that level. So, we really try to do that and then assess them as things go on. There are still companies that may start out as a story stock and evolve over time to turn into great companies. So, we want to make sure that each earnings call, each data point that we receive continues to support our short thesis. And we have to be ready to change our thesis if things don't continue in the way we expect.

Charney: In terms of 2014 specifically, it was a relatively good year, especially on the alpha side. Is there any favorable attribute that you might point to--maybe the market gained a little bit more rationality at least with some of these story stocks--that you could say was one of the keys to your success?

Motamed: Yeah. I think the IPO market was interesting last year. There were a lot of short opportunities coming out. There were a lot of companies that didn't have free cash flow characteristics, were coming out with massive valuations. Analyst estimates were unreasonably low initially, and it positioned them to pop very aggressively on those first few beats. And then those same companies, once the reality caught up with the situation and the fact became visible that these aren't big free-cash-flow-generating companies, they don't have good prospects of making any money over the near term, and those analyst estimates that had been sort of managed through the process could no longer be managed, because with every beat and raise, those estimates moved up. And yet the fundamentals of the businesses slowly deteriorated.

So, you got rid of that catalyst of beating estimates and, at the same time, didn't have the underlying, fundamental value catalysts. So, those, in many cases, worked out very well for us this past year.

Charney: And what about 2015? Is the trend going to continue on the short side? Do you see more opportunities on the long?

Motamed: I think some of those names still are existing. The IPO market is still there and strong. People have become much more rational with the pricing of these IPOs. There was a period where we were seeing IPOs coming out at 50 and 100 times sales, which is very difficult to justify. I think as we look on to the short side in this next year, I think the biotech sector is particularly at risk. It's an interesting sector because it's entirely built on stories.

If you look at the lifecycle of a biotech company, when they start out and launch a Phase I trial, by the time that drug comes to market, could be five to seven years. So, you can tell a story for five to seven years. But the problem that you encounter is that by the time that comes time to be materialized, the environment could be very different. Also, these biotechs are capital consumers. So, while fund flows are coming into the equity markets, it helps them because they're constantly spending R&D for the first six or seven years of that cycle, and they only materialize in generating cash flow so far out of that cycle.

So, if we see any deterioration in fund flows, first of all. And then secondly, a lot of these companies just aren't going to materialize. Their market sizes are too small. One interesting data point I read recently was that if you look at it from 2010-14, if you look at the top 100 biotech drugs out there, the average annual regimen price went from $1,200 and $9,000. So, that's about a six-fold increase in the price per annual regimen. Meanwhile, the patient populations came down by 50%. And now you take these same biotechs--I think there have been 200 or 300 IPOs in biotech land. Extrapolate the fact that these are not coming to market for six or seven years and consider that trend--which has been what's driven biotech to a large extent over the past few years--and the capital flows, and I think it sets itself up to be a very risky situation for biotech investors in the next year.

Charney: Well, I look forward to watching your funds in 2015, and congratulations, again, on the award.

Motamed: Thank you very much.