Examining Whitney Tilson’s recent troubles with his NFLX short and the recent realignment of his portfolio  suggests to me a value-based short-selling rule: only short zombie stocks. By that I mean a company that is literally the living dead – a company whose investors/management have not caught on to the fact that the company is already dead on its feet.

I read Kathryn Staley’s The Art of Short Selling and came away thinking that the most important rule in short selling is to never short good companies. Companies like that won’t have impending accounting or legal issues (that’s part of why they’re good companies), so shorts are only based on valuation or belief that there is an impending quality decline. I remember seeing a link years ago to this post about the surprising success of Netflix and it stuck with me. Predicting that a valuation is irrational brings to mind that old Keynes saying about the markets staying irrational longer than you can stay solvent. Being right isn’t enough – you have to be right in a timely manner, lest your investors get frustrated and wander off. This aspect becomes less important if you’re only managing your own money but you need to remain confident in your judgment through bad times (easier said than done…). Not only that, but you need a timely price drop to get a solid IRR since short selling has a natural maximum return – no ten-baggers here.

Even worse, valuation and quality decline shorts assume that the company can’t meet the inflated expectations or solve its potential problems. That’s not a likely occurrence, but if it happens you will suffer permanent loss of capital and you must respect the danger.

To me, the zombie rule is fundamentally about keeping a margin of safety. Value investors want to minimize downside first and foremost (“Rule #1: Don’t lose money”). The way to minimize downside in short selling is to find companies that have no realistic upside. That sounds like it ought to be simple, but it there are a few complications.

Truly embracing a margin of safety means that this rule might exclude the short selling of some companies that have committed accounting fraud. Consider David Einhorn’s battle with Allied Capital: that one took six years to play out. I haven’t read Fooling Some of the People, but I’m guessing the returns on that investment weren’t what you’d call spectacular – he was in it for the principle, not the payoff. Most shorts aren’t going to turn into that kind of half-decade slugfest but it’s important to recognize that some companies are better equipped to wage PR battles in their own defense.

We can look to another of Einhorn’s shorts to see a great example of a zombie stock: Lehman Brothers. There wasn’t simply a wildly optimistic valuation or an impending decline in quality – the combination of leverage and low-quality assets left the company dead on its feet.

About a month ago I wrote up Cagle’s (CGL.A), which looked like it had the potential for zombification due to constantly rising corn prices. So far it looks like that one has come half-true since it posted a significant loss for the most recent quarter and equity now looks to be below the $40M cutoff in its debt covenants. It’s down about 12.5% since the announcement and it’ll be interesting to see where that goes. I think I’ll be revisiting this topic in the future to try to refine specific value rules for short selling.

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