What makes a great short? (Part I)

In this four-part series, we will examine in detail the four specific characteristics that we think make an attractive short.

The first of the four specific characteristics that we think make an attractive short candidate we call: Thematics or Structural Declines. Here, we are referring to multi-year, structural changes that we see happening – typically at the industry level. We are not talking about any changes that are merely cyclical in nature and might reverse over the subsequent quarters.

When a business is positioned poorly in a structurally declining industry or sub-sector, it often cannot help but to contract. This creates a very difficult set of circumstances for management. Typically, revenues are declining; and, to the extent any costs in the business are fixed – which there almost always are, then profit margins will contract at the same time. The combination causes an accelerating decline in profits and cash flows. The financial flexibility to invest in the business to reposition the company is often limited in such a scenario.

The market typically underestimates the extent of these headwinds that are created by such a positioning in a structurally declining industry or sub-sector. And therein lies the opportunity on the short side.

Examples of such a thematic or structural decline include technologies that either become obsolete or are displaced by newer technologies. An obvious historical example is how the digital camera displaced film cameras. Interestingly, smartphones with inbuilt cameras then displaced digital cameras.

Screen Shot 2016-04-01 at 12.39.56 pmSmartphones and tablets have also displaced PCs to an extent.

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Physical books have been displaced by e-books. Physical mediums of music, such as CDs (which displaced cassettes and vinyl), have been displaced by digital forms such as Spotify and Pandora.

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Offline advertising is being displaced by online advertising.

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And within online advertising, mobile advertising is displacing desktop advertising.

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This is simply because we are spending more time on our smartphones and less time on our desktops.

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Consumer behaviours are also changing – particularly amongst the younger generations. Consumers are increasingly catching Ubers, not taxis; and staying in Airbnbs, not hotels. Consumers are increasingly watching Netflix and Apple TV, not free-to-air TV. In Australia, for example, viewership of free-to-air television channels amongst 16-39 year olds was down by around 15% in 2015.

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Even television consumption patterns are evolving. According to Deloitte’s 10th Digital Democracy Survey of more than 2,200 U.S consumers, 70% of respondents binge watch an average of five episodes in one sitting, with 35% of millennials doing so on a weekly basis.

An alternative example of a multi-year thematic is the Beijing corruption crackdown and the impact this has had on global luxury goods industries. Look at the growth of registrations of luxury cars in China, for example.

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Instances of structural overcapacity can create multi-year oversupplies within industries. We have seen this in many commodity markets over recent years, such as copper, coal and aluminium.

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Thematics and structural declines within industries create fertile ground for attractive opportunities in Montaka’s short portfolio. For poorly positioned businesses, there is often little that management can do to escape the organic deterioration in the business. The headwinds persist for years, not quarters, often allowing for a longer-term opportunity on the short side.

In the next instalment of this four-part series, we will examine the second of the four characteristics that we look for in an attractive short candidate: Divergent Expectations.

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Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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