Think Short; Becoming a Skeptical Buyer

Investing

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I’ve been investing in stocks for 12 years. I opened a brokerage account in my dorm room at the University of Waterloo in 2005, and have since built a nice portfolio. But it’s certainly not perfect. One of the most important things I’ve learned, and accepted over time, is that I’ll never have a perfect track record, or even close; i.e., ~100% winners. My portfolio will have losers now and in the future.

That being said, I’ve become a much better investor by limiting my blow-ups, whether that’s through not selecting as many future severe under-performers, or promptly selling out of a declining position in my portfolio that’s violated my thesis (i.e., initial reason(s) for buying a stock). So, now I consider myself a perpetually skeptical buyer, meaning that I’m consciously, and decidedly not easily convinced; I have doubts and reservations about the markets, and stocks… all the time. I’m always mindful about why I’m interested in a stock. My interest won’t ever be based on a ‘tip’, emotions, or a ‘hunch’. I conduct my own extensive, independent research on every stock before I initiate a new position in my portfolio. If you’ve read my new book,Capital Compounders, you’ll know that I think only 10% of the Canadian stock market is actually investable, with ~ 50 truly exceptional businesses. The same ratio can apply to the U.S. market, but an even lower one in many international markets, where maybe 5% of stocks are actually “investable”. Indeed, there’s a lot of bad companies, and even more mediocre ones, publicly traded on the stock market. I’m that skeptical.

Since becoming an increasingly “skeptical buyer”, which has come through experience, and many mistakes, I’ve been enthralled with the world of short sellers. People like Marc Cohodes, Carson Block, and Andrew Left who initiate shorts in companies; betting that a stock will fall in price, and then gaining if that scenario plays out in the market. Studying these prominent short sellers has improved my investing success. I employ these short sellers’ shorting frameworks in my own stock selection process by removing stocks from my universe that I’m skeptical about based on many of their short criteria. What remains in my watchlist, and then in my portfolio, are companies/stocks in which I am least skeptical. And that’s really the best I can do because I’ve accepted that ‘I don’t know what I don’t know’. I’ll never know everything at any given time but I can adjust my positions based on new inputs that I learn over time. This is why I concentrate my portfolio in small-cap and mid-cap stocks where I feel I can have an informational edge because of the low analyst coverage and/or institutional ownership in the space.

Now that I’m a more skeptical buyer, before I initiate a new position, I always ask myself, “What can go wrong?” Because, who wants to lose money… And if I do initiate that position, I always make an agreement with myself that I’ll sell out of the position if there’s an violation in my initial thesis. Things change. I can be wrong. But I don’t want to be emotional about it.

Ok, let’s cover one short sellers’ framework that you can use in your own stock selection process to become a more skeptical buyer. I called up Marc Cohodes this summer and cited some points from our discussion in “The Truth is Out There” issue. But that was just about the Canadian housing market in general, where I concluded “something’s gotta give”. So, for this issue, here’s Marc Cohodes’ short selling framework; how he thinks, and selects stocks to short:

“I never, ever, ever get involved in what I would call open-ended situations… I have avoided pie-in-the-sky names. To use an analogy, I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I’m interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground. Instead of open-ended situations, I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets. I look for change, I look for ‘if this goes away tomorrow will anyone miss them’?…” To add, Marc usually bets on the jockey, not just the horse, meaning that there’s (unfortunately) rotten managers out there. And he looks for companies that are “frauds, fads, or (impending) failures”, stalks them (Marc calls himself a “stalker”) until they’re weak, and then quickly pounces, initiating a short position; riding the stock down, covering when the time is right, and making money through the process. Again, this thinking can help you in avoiding and/or removing bad stocks from your portfolio. It’s certainly helped me. Always be asking yourself:

– Is management good? Are they honest? Professional?
– Can this company potentially be a fraud (Enron), fad (Heelys), or failure (Blockbuster)?
– Does their product/service have staying power? (i.e., durable competitive advantage)
– Will I know the signs to look for when a company starts to turn for the worse? (especially on the balance sheet, and income statement)
– Do I have the emotional fortitude to pull the sell trigger if I’m wrong?

Becoming a more skeptical buyer isn’t easy. It takes experience and learning from ones mistakes in the market. Being skeptical has certainly improved my investing performance as there’s less ‘blowups’ in my portfolio over time.

Don’t forget to join the Capital Compounders Club! There’s aready 200+ members on Facebook discussing their growth stock ideas in the stock picking competition.

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