Intro

There are a lot of so-call ‘rules’ that you’ll see bandied about on Ticker Talk. In fact, they’re repeated so often, they attain an almost mantra-like quality. You almost expect them to turn into Latin recitals, the central tenets of the one true faith.

Which is a pity, really. All rules are meant to be broken. You simply have to know when, why and how.

Lets concentrate on one of those rules, the rule against long term shorts. Put simply (am I capable of doing it any other way?), the rules against long term shorts states that only fools invest short stocks long term. As a rule of thumb, that’s a pretty good one. But it’s only a rule of thumb. There’s a lot of money to be made on long term shorts if you’re willing to assume the risk and, as we’ll see, even the risk can sometimes be a good thing.

Getting existential

I’m going to start off by assuming that you already know all about shorting.

What’s a long term short? Anything that isn’t a short term short. Oh goody. What’s a short term short? And suddenly it isn’t so easy. Because here’s the thing: whether a short is long term or short term has very little to do with the amount of time we actually hold the stock. In the words of Hannibal Lecter, first principles.

Why do we short a stock? Because we think it’s overvalued.

How do you determine the value of the stock? At this point, the more clued up among you may be starting to think about the likely opening weekend gross of the movie and then using some kind of discounted ROI (Return on Investment) formula to arrive at a net present value. Which is all well and good, but there is a simpler real world answer. The value of a stock is whatever people are prepared to pay for it. Supply and demand, baby, supply and demand. To that HSX adds a second limb: or whatever HSX says it’s worth.

Shorting is based on the idea that there is an intrinsic value to a stock, which is independent of its current valuation. If the intrinsic value is lower than the current valuation, the stock is overvalued and there’s a shorting opportunity. How do we determine the intrinsic value of a stock? There are three basic methods:

a) Absolute value. Take, as an example Windtalkers (WINDT) which is currently trading at $41.10. Let’s assume you think it can open to $40m. If you cashed out your investment then, the value of each stock would be $116. Hence the absolute realisable value of WINDT is $116. This is typically the way a newbie values stock and is notoriously bad, because it ignores the time value of money.

b) Net present value. Take the absolute value and then discount it using ROI to arrive at a net present value. Using an ROI of 1% daily gives us a net present value of (gulp!) $7.37 for WINDT. If you don’t understand ROI, please read Tom Miller’s stellar explanation.

c) Relative value. This compares the value of stock to similar stocks with similar release dates and patterns. For instance, The Visitor (PLNTA) is a big summer release, much like WINDT. PLNTA is trading at $62.40, ergo WINDT should be trading at approximately $62.40. WINDT is therefore undervalued, whereas PLNTA is overvalued. The reasoning isn’t as intellectually rigorous as net present value, but it has its uses.

Err, shorting

So now we know how to measure the intrinsic value of stock. If the current value of the stock is higher than the intrinsic value, we should go ahead and short, right? Wrong. Because there is one final assumption upon which all shorting is based. Ready?

Shorting is based upon the assumption that there will be some event which will cause the current valuation to follow the intrinsic valuation.

If that event (lets call it an ‘Exit Event’) doesn’t happen, the stock price will never fall, no matter how ‘overvalued’ it may be. Right, now we can finally get back to the definition of a short term short. A short term short is any stock for which there is an identifiable Exit Event in the near future, following which that stock will be trading lower than its current price. A long term short is any other kind of short.

What do we mean by ‘near future’? I’d argue any film which is within a film few weeks or release or delist, or which has just been/is about to be the subject of news. Each one of these events will drive the share price and hence is a potential Exit Event. If they drive it down, the stock is a short. Every time you short a stock, you should ask yourself what’s the Exit Event. It’s all very well saying that the net present value or the relative value of a stock is far lower than its current valuation but, unless there’s an Exit Event, you’re not going to see a profit.

For many, many films the only Exit Event is adjust, with a second (delist) tacked on at the death. In other words, it doesn’t really matter what the relative value or net present value of a stock is, your only Exit Event is going to be on adjust so the only valuation that matters is the absolute value. Most stocks trade at below their absolute value (for instance, say what you like about the merit of Stuart Little 2 (STLT2), but nobody is seriously claiming it will open to $2m), so the tendency is for the stock price to rise over time. Indeed, so ingrained is this tendency to rise over time, that even stocks that look fully values on any rational basis will continue to gain – market conditions permitting. All other things being equal, if you pick a random stock, go long. That’s one of the reasons for the rule against long term shorts. The other is that there is unlimited downside. If you go long on a stock, the most you can lose is 100%. OK so nobody likes to lose 100%, but at least that’s a cap. Ask anyone who shorted The Blair Witch Project at $20 and saw it adjust to $100.

Enough already, tell me what it means

After all that, do you still really want to go short some stocks? Yes? Well, here are some of the things you might want to watch out for.

Limited releases
Psst. Check out the Box Office Charts. See how little those movies make? Now, check out the Release Schedule. It doesn’t take a genius to work out that there’s money to be made from shorting limited releases. Now, you could easily wait until the film opens to confirm its box office potential, or lack thereof. Problem is that it’ll most likely have lost most of its value by the time that happens. Hence the long term short. The trick is to look for films with absolutely no redeeming box office qualities whatsoever. Nothing remotely approaching a star. Subtitles perhaps. Why? Because we’re still carrying that potential downside. Don’t want to give it a chance to come out and play.
Grossly overpriced upcoming releases
The trick about shorting stocks is to do so just before they start falling. Which is both self-evident and incredibly hard to do. Sadly, there’s never an announcement that a stock is about to fall. The problem is that you don’t know whether the drop is going to be steady or sudden, or indeed when it will happen. Bearing in mind the limitless downside, some people don’t like placing shorts more than a week before release. Other are happy to go short up to a month earlier. And then there’s guys like me who will happily go short months in advance. If a movie looks grossly overpriced, it’s the only way to guarantee you catch the entire fall. Look for movies that are already above any realistic adjust price and have a lot of downward potential. An example is Gun Shy, a Sandra Bullock film that was once price at $48, higher than Forces of Nature adjusted. Except this was a $7m independent film, with Sandy taking on a supporting role. I shorted at $48. It eventually delisted below $2.
Straight to Video
Any film that goes straight to video or straight to cable will delist at zero. A perfect shorting opportunity, right? After all, you return is 100%. At any time, you can reshort, and your return is again 100%. But take care. A lot of these stocks trade very low. If you short a stock at $0.50, your potential return is still 100%, but it wouldn’t take much for the stock to reach $2, lumbering you with a 300% loss. Sure, in the long run, you’ll get it all back with interest, but in the long run we’re all dead. Pick stocks that are still pricey enough to give something up when they drop. The other advantage is that ‘minor’ changes is price won’t quite have the same devastating effect on your investment.
Limbo-locked movies
Was a time, I thought that the hardest thing about a movie was getting the damn thing made. I’m not so sure any more. Could be the hardest thing is securing distribution. Even films with established distributors may never see the inside of a theater. Miramax seams to be especially bad in this respect (ODECR anyone? TAKED?). How much harder if it’s a true independent with no distribution deal in place? An example of what I’m talking about is KILLD. Best I can tell, this has been sitting on the shelf, untouched, for quite some time. The fate of many of these films is to wind up going straight to video or cable (I think BTDIE was the last such victim). If they ever do get released, they’ll likely have the kind of release for which the word ‘limited’ hardly seems appropriate. How about ‘constrictive’? The upside to this kind of short is that you will almost certainly profit handsomely from an Exit Event. The downside is that you have idea when that Exit Event will occur. Hey, I never said it was perfect.
Crash hedging
So the price of stocks tends to rise, does it? Well, yes, but that’s not the same as saying it always rises – as your ports have probably witnessed over the last few weeks. Personally, I’ve lost $5m and jumped four places. Crashes result in bloodbaths. Even the sort of thing we’re experiencing now leads to bleeding ports. How to counter this? Simple. Hedge your port. If you hold everything in your port long, you’re primed for growth. Which ain’t gonna help you if the market decides to fall. No matter how much of a bargain the stocks were before (and boy, are there some bargains out there now), that ain’t gonna save them. Here’s where shorting can hedge your risk, in much the same way that derivatives in real life are used to hedge risk. We’re actually using the risk of the short as a positive.

Simply short a selection of pricey stocks (CASTA anyone? How about CHARL?). Sure, if the market keeps on rising, you’ll lose money on them, but if you pick the right stocks, they won’t have far left to rise. Anyway, any loss on them will more than be made up for by the rise in the rest of your portfolio. If the market crashes or declines, yes it’ll hurt but the shorts will cushion your fall – unlike the other traders out there. The key is knowing when to crash hedge. Too early and you’ll be losing money unnecessarily. Too late and, well, it’s too late. The obvious time to hedge is following a sustained bull session in the market. If the prices of upcoming releases in the next four or five months look close to or above their likely adjust price, we may be due for one of those infamous ‘market adjustments’ – the perfect opportunity for crash hedging. Remember all that talk at the end of August about a crash? OK, the crash never happened, but anyone who crash hedged off the back of that talk would be laughing right now.
Wrapping up

I could basically carry on ad nauseam, so its probably as much for your benefit as anything that I stop now. Briefly to recap, to state that you should hold a long term short is a gross simplification. The potential risks of a long term short are large and unquantifiable. However, they can at least be identified and are capable of being minimised. There’s certainly money to be made out of them and they have a place in balanced portfolio – but equally, they’re probably not for beginners.

If I had reduce all of the above into one final thought, it would be this: if you’re going to short a stock, know why. And by that, I don’t mean some wholly-headed ‘it looked overpriced’ thought. Really, really know why.

Wow. That was a lot to get through. Next time, I’ll do something really lightweight and inconsequential. I promise.

-Huy