Lazy shorting to hedge my portfolio – it is all about finding companies that would underperform on relative basis

In early 2021, equity markets are all the rage and off to some explosive start, building on massive post-covid19 rally from 2020. S&P500 is hitting new all time high – it is very exciting times.

In hedge fund-speak, S&P 500 continues to “grind up” nicely. Bulls are obviously excited about the re-opening trade, and bears are constantly concerned about the valuation.

I am an optimistic person, but that does not mean I believe stocks only go up. Stocks can move up and down AND they can go down for extended timeline – long enough for me to capitulate because the loss is too painful.

So in the good times, I like to buy some insurance – good insurance if possible. In portfolio construction, that would mean adding on short exposure – whether it be through shorting stocks or buying put options. As the market climbs, I have been increasing my short exposure. My short exposure changes everyday, but I plan to target having 70-80% net long exposure (80% long exposure offset by 10% short exposure – but no leverage, but with cash / dry powder on the side).

Given the massive bull-run and the fact that most investors are very long-biased (very susceptible to macro events that could take down stock market), I wanted to share my thoughts on shorts, including my rationale for 70-80% net long target and methods of picking my lazy shorts (not active shorts).

Rationale for 70-80% net long target

I am an optimistic person and I want my portfolio to be continuously exposed to the cutting edge innovation. Stock market continues to show that it really pays to be an optimist and there is a massive graveyard of pessimists.

At the same time, it is more important to ride the update than avoiding the drawdowns. As we have seen time and time again (initial covid19 sell off or Presidential election), growth stocks sold off more than “safer” names, but they came roaring back and significantly outperformed value names.

Historically, there also has been much longer period of bull market than bear market – particularly since great financial crisis of 2008. Extended monetary expansion has created a lot of money and scarcity value of innovation has only stretched the valuation of key innovation companies.

Key innovation companies of 21st century tend to be capital-light (they don’t need much capital expenditure to grow – except Tesla/$TSLA) and be extremely scalable (creates a heavy winner-take-all market dynamic) – all of which makes internal R&D carry extremely high ROIC and that makes them excellent capital compounders. Therefore, I want to make sure my exposure to innovation remains very high and only want to use minimal insurance to prepare for rainy day. My capital, unlike those of ECB or Federal Reserve, is SCARCE!

My method for picking lazy short ideas as portfolio insurance

I also do not like shorting companies in general – particularly innovative companies whose progress and products will make lives easier for the world. At the same time, I need to make sure the safety of the portfolio – so I screen out companies 1) whose stock price (different from value) could go up significantly (going up in-line with market is fine), or 2) whose innovation engine is very strong. In hedge fund community, this method is called “identification of funding shorts” – short positions that you put on in order to fund your long positions so that the portfolio manager can maintain the size of the portfolio while controlling market exposure. Below are key criteria that I use

Dinosaur companies: dinosaur companies are victims of macro trend, whether it be demographic or technological – $GME / Gamestop fits here, but it is important to stay away from companies with very high short interest or with strong management teams. Change in equity story and even a sliver of hope can push stock prices very high as “turn-around” call options come into the stock. $CSCO/Cisco fits here – traditional network companies who supply products for in-house cloud are suffering from technological trend of moving to shared cloud.

Asset buyers: Some companies must continue to buy to drive growth, such as large cap biotech companies. At a high level, large cap pharmas source innovation through acquisition and they are now almost relying on them. Each M&A of biotech companies is transferring value from large cap pharma shareholders to smid cap biotech shareholders. As these companies are constantly entering value-leaking transactions, they can make good candidates for lazy / funding shorts.

Mega cap companies: Mega cap stocks are excellent candidates for lazy shorts. They are generally never acquired at ridiculous premium. They also constitute significant portion of S&P 500 or various index funds – therefore their share prices are largely tied to index movements and idiosyncratic events. Given that I am just looking to hedge out market risk primarily, mega cap companies serve as great and relatively inexpensive hedge (high liquidity also makes borrow cost very low).

Lack of catalyst over the next 3-6 months: This category is based on expectation of other market participants, particularly hedge funds who must remain focused on single stock ideas while keeping their market exposure low. If there is a company with no real catalyst for the next 3-6 months or a company pushes out a catalyst event, you will notice that stock price suffers for an extended time. It is because 1) hedge funds that were in the name for the catalysts are getting out and 2) hedge funds looking for lazy shorts are piling in – both of which creates strong sell-pressure on the stock price. Knowing this hedge fund mentality, I try to move ahead of them and I can because I have very small capital base and I can move in and out without moving prices. This is particularly relevant for biotech companies.

IN CONCLUSION

Alpha shorts are great, but they are very hard to find and the timing is particularly more important with alpha shorts. I have a normal day-to-day job that I must focus on, so I try to avoid alpha shorts – it is uphill battle against hedge funds as well.

So I spend my time looking at innovative companies and just screen for passive/lazy/funding shorts to hedge out market risk. Hedging is not just insurance – it helps you with mentality by padding P&L during severe sell-off so that you can 1) hold onto your best ideas (so you keep the upside when the market returns to bull market) financially and 2) use earnings from short positions to double-down on your best ideas that are selling off sharply.

Remember – investing is a process and compounding game. Avoiding catastrophic loss will generate significant alpha 10-20 years from now. Best of luck to everyone!

*not investment advice