‘We believe there is a record disconnect between stock prices and reality,’ says Spruce Point CIO

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A lax regulatory environment, the pervasive influence of passive funds (driven by index funds and ETFs), and a continued commitment among central banks to maintain low interest rates are creating a golden age for short sellers.

At least that is the view of Ben Axler, founder and CIO of New York-based Spruce Point Management. And it is a view shared by other committed short sellers. As Jim Chanos recently told the Financial Times, ‘we are in the golden age of fraud’. Case in point: Chanos allegedly pocketed a cool USD100 million (approximately) by shorting German fintech company Wirecard.

Axler, by his contrarian nature, was hardly surprised by the Wirecard affair. After all, he spends his days forensically picking apart the financial and management DNA of US corporates to identify the best short opportunities.

When I ask him about the ongoing misperception of short-sellers, as though they are somehow Dracula-like figures sucking the lifeblood out of good old corporate USA (or any other country, take your pick), Axler is quick to respond:

“From our point of view here in the US, where we focus our short selling strategy, there is a structural bias to recommend stocks through positive research, positive endorsement and present a strong narrative that companies wish to tell.

“There is not enough contrarian research that finds problems with the rosy stories companies are telling investors.

“Short sellers should not be viewed as villainous but rather as investors with contrarian views that go against the prevailing consensus.”

Axler’s first short sale was a company called ZST Networks, a US-listed Chinese company. Upon reviewing the financial statements and public filings, Axler became so sceptical of the reporting and business “that I felt compelled to make my research public”.

The stock ultimately went to zero and was delisted.

“Ever since, I’ve felt strongly that there is a great need for more alternative and independent research in the investment industry,” he asserts.

This is not a self-serving sentiment being voiced by Axler. It’s wider than that. Since the last financial crash in ’08 the equity markets have positively rocketed. Trying to strategise and find a weakness in the system has gotten harder, and almost as tall an order as David facing that good old villain of lore, Goliath.

The role of short sellers such as Axler, Chanos and Safkhet Capital’s Fahmi Quadir is to fire slingshots in an attempt to keep the markets honest, regardless of regulatory obfuscation.

One of Axler’s gripes in particular is the role of auditors.

“One of the problems here in the US is we have an entrenchment of auditors,” he says.

“We’ve written research reports on companies who have had the same auditor for 30 years.

“A second issue is who is the audit engagement partner responsible for signing off on the audit?

“We are seeing situations here in the US where the audit partner doesn’t even have the requisite industry experience of the company they are auditing. There needs to be more rotation of auditors, more shareholder pressure should be applied, and there needs to be greater accountability on audit partners who sign on the dotted line to say they’ve reviewed the financial statements.”

A number of years back, I interviewed Hugh Henry of Eclectica Asset Management. He spoke of the markets suffering from what he called a Platonic simulacrum. In other words, the markets failed to mirror reality; they were more Disneyworld than real world.

The same could arguably be said about today’s economic reality, where the Dow Jones continues to be propelled by technology stocks, even though unemployment remains above 10 per cent (albeit down from 14.7 per cent in April).

“I’ve never seen an environment where, for one, interest rates are so artificially low. That has numerous side effects ie propping up companies with low borrowing costs that otherwise would not be able to sustain the amount of debt they have. Nor have I ever seen an environment that is so anti-regulatory for investigating and enforcing large corporate accounting scandals,” argues Axler.

Twenty years ago, the SEC was prosecuting numerous large corporate accounting scandals including the likes of Enron and WorldCom.

“Today, I would challenge you to name one large corporate accounting scandal charged by the SEC,” says Axler. “It appears their focus has been on protecting retail investors from bitcoin scams. If you’re a large US corporate operating in this environment, you’re able to enjoy a very lax regulatory regime.

“Low interest rates, a lax regulatory regime, and a move towards passive investing, which has created a disinterested shareholder base – all of these factors make for a golden age of short selling.”

With such economic uncertainty – is this really likely to be a V-shaped recovery? – one might understand why short sellers like Spruce Point see plenty of grist for the mill.

With the amount of monetary easing in the US and the inflation of the market, the disparity of where a lot of capital is going – mainly to well-known technology names – versus smaller and mid-cap names is significant.

“This is creating a very big divide in terms of valuation gaps. We believe there is a record disconnect between stock prices and reality,” says Axler.

Like every short-seller, Spruce Point does a thorough bottom-up review of the companies it analyses. This might include looking at management teams, boards, the accounts, the quality of the financial presentation and the quality of financial disclosures.

In his view, the best short right now is one that is poorly positioned in a Covid-19 world, and has issues related to some of the points made above.

One of those shorts includes Prestige Consumer Healthcare (PBH); a business that is very much tethered to bricks and mortar retail and which sells a lot of over-the-counter branded products that are off-patent.

“We believe e-commerce is set to take more market share and grow in this environment, so companies that have a poor e-commerce strategy or positioning are going to be at a disadvantage,” suggests Axler.

Another recent example was Forescout Technologies (FSCT), which was set to be acquired by Advent, the PE group, when they announced the deal in February before the WHO declared coronavirus a global health pandemic.

“We wrote a letter to Advent explaining to them why we thought they had the opportunity to lower the price. We were convinced that the deal price that was set should have been negotiated lower and we were proven correct on that as both parties ended up revising the deal price,” states Axler.

ESG is a whole other set of opportunities for short-sellers, as companies profess to uphold the highest ESG standards, whereas in reality that isn’t necessarily always the case. In the UK, the fashion group Boohoo was recently found to be paying staff in some of its supply chain factories less than half the minimum wage.

“Stay tuned. You’ll soon hear us opining on certain companies in the near future, which are performing very poorly on ESG,” Axler says with relish.

Although he admits it has gotten harder to be a short seller in the strange financial markets of 2020, Axler is unswerving in his belief that applying unique research, conducting surveillance on companies and writing letters to governments to request information that is not available, “are ways that sophisticated short sellers can find an advantage and make money in this market.

“Good old-fashioned human research will never die.”

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James Williams
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