Hedge Fund Short Positions: High Operating Leverage the Common Theme ~ market folly

Tuesday, January 12, 2010

Hedge Fund Short Positions: High Operating Leverage the Common Theme

Upon reading various hedge fund investor letters and conversing with colleagues in the industry, one thing has become quite clear: hedge funds got their asses kicked on the short side of the portfolio in 2009. This is by no means a shocking revelation given that the stock market itself has risen over 70% from the lows back in March 2009. After all, a rising tide seems to lift all boats. While the negative performance of short positions over the past year is a common trend, we want to focus on a theme found in many of their portfolios.

Here's the common link: many hedge funds have shorted businesses with high operating leverage. Amidst the crisis of the past two years, operating and financial leverage became quite a detriment to various companies. Hedge funds quickly recognized this and shorted shares of companies who would struggle with this burden in an uncertain economic climate. At the time, it was a poignant move. However, markets are often driven by perception (versus reality).

What are we talking about here?

We're simply pointing out that the high operating leverage that was once seen as a detriment to the companies that hedge funds were/are shorting can now be construed as an attribute.
According to the market, the economy is recovering and things are slowly but surely getting better. (More appropriately, the markets have been the beneficiary of massive capital inflows). Regardless, this market rebound re-instills confidence and shifts investor sentiment. And, most importantly, it reverses risk tolerance.

The very companies investors avoided like the plague during the crisis are now catching a bid because investors' risk tolerance has returned. Many hedge funds missed this swing in perception and bore the brunt of the blow. It doesn't matter right now if the company could potentially have problems due to their operating leverage. Right now, all that matters is that risk tolerance has returned and risk is 'in'. This goes back to the age old market debate of perception versus reality.

We can't tell you how many times we've seen hedge funds comment on the 'mistakes' they made in 2009. Almost all of their mistakes are on the short side of the portfolio. And while they don't name specific stocks, they mention the sectors and attributes of their shorts. Many of their errors have come from shorting companies with high operating leverage that rallied furiously ahead of the rest of the market. While hedge funds were bound to take losses on the short side of their books because they had to be short something in this monster rally, it's interesting to note that the vast majority of their mistakes boil down to companies with that same common link. Looking back, it's a bit of a 'captain obvious' moment.

Andreas Halvorsen's hedge fund Viking Global started feeling the pain from their shorts as early as the second quarter. Chase Coleman's hedge fund Tiger Global had problems with their short positions as early as the first quarter 2009. Many of these hedge funds were (and still are) shorting banks, REITs, luxury hotel chains, and capital goods companies (industrials).

More than anything, this just reiterates the fact that caution must be exercised when shorting companies with high operating leverage. Arguably even more important, this showcases that it pays to monitor market perception and investor risk tolerance. Many hedge funds absorbed the initial ramp higher in their short positions but eventually entered the house of pain as they stood by their conviction. This is why sometimes you have to pay attention to more than just fundamentals.

It's interesting to look back on this now and see such a common theme. As we like to say: the opportunities clear in retrospect are often unclear in prospect. Still though, some will argue that 2009 was bound to be a losing year on the short side regardless of the companies targeted simply because you were fighting an uphill battle... against the government's $1.5 trillion blank check.

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