What makes a great short? (Part II)

To outperform in investing, one needs to take a different view to the market; and that view needs to be right. So at the very least, one needs to understand where they are different to the market; and why they believe they are right.

The price of a stock is effectively a numerical representation of a set of assumptions about future value drivers of the underlying business. When you buy a stock believing it is cheap, you are effectively saying that you believe the market-implied expectations built into the stock’s price are too conservative. Similarly, when you short a stock with the expectation its price will decline, you are effectively saying you believe the market-implied expectations built into the stock’s price are unreasonably high.

Which brings us to the second of four specific characteristics that we think make an attractive short: Divergent Expectations. (For a review of the first characteristic, Thematics / Structural Declines, click here).

As the name suggests, Divergent Expectations refers to the situation in which we believe the market-implied expectations built into a stock’s price are unreasonably high. That is: there is a divergence between market-implied expectations for the future and our assessment of reality.

This concept is best illustrated with a live example from the Montaka short portfolio. Consider Prada (HKEx: 1913), the luxury brand and maker of high-end leather goods. In 2014, revenue growth evaporated after multiple prior periods of at least 10%YoY growth. Furthermore, profitability dipped after tracking on a steady incline. The primary reason? Beijing’s corruption crackdown was starting to take hold which limited the otherwise strong demand from Chinese party members for luxury goods.

The question at the time was: where to from here? Well, as illustrated in the charts below, consensus analyst expectations were for revenue growth to reaccelerate straight back up to +8%YoY and remain there going forward; while profit margins would resume their incline back to historical levels.

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Were these expectations appropriate? We believed not. An assessment of the drivers that led to the decline in revenue growth and profitability led us to conclude that these were more structural in nature, not cyclical. Namely, we held the view that President Xi was serious about his purge of party member corruption and was unlikely to reverse his stance any time soon. On this basis, we believed the market-implied expectations built into Prada’s stock price at the time were unreasonably high – a case of Divergent Expectations.

Fast forward to one year later and the inevitable played out. Quarter by quarter, Prada delivered results and guidance that underperformed the expectations that were built into the stock’s price. The stock price continually declined (see below) and expectations were subsequently lowered (see current expectations on charts above). We even talked to the press one year ago to explain exactly this view. (See here and here).

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You may be wondering how or why these situations arise? We do see opportunities like these time and time again – one of the reasons we believe Montaka’s short portfolio is so valuable. In our view, these opportunities stem from the behavioural make-up of human beings. Humans are inherently optimistic and tend to live in denial for periods of time in the face of new, unpleasant information. Furthermore, humans tend to suffer from recency bias when attempting to make forecasts.

These human characteristics mean that stocks will be mispriced from time to time – and it is our job to find these mispricings and profit from them on behalf of our clients. In the next instalment of this four-part series, we will examine the third of the four characteristics that we look for in an attractive short candidate: Asymmetries.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.

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