Well that's a bit contrived but we are in a race; it's the shorts against the longs. The shorts want the Tullow price to go to 1p or less and the longs 100p or more. Where are we at the moment? Somewhere in the middle at 45p. There are actually at least 5 hares in this particular race; Odey, Pictet, Varde, Whitebox and Key Group. Key Group are flagging a bit and have dropped to 0.49% or less which means that they don't have to report anymore. Odey and Pictet seem convinced of victory and have raised their stake in the last week of February. Varde has decided they're too far ahead and have repaid 0.32% of the company value on 19 Feb. I expect they're very pleased with themselves as that cost just £1.54m on 19 Feb and would cost £2.06m in todays money 11 days later.
So why do investment managers short stock? Broadly speaking it's for two reasons, the first is that they've gone through a discounted cash flow based valuation and looked at any other factors such as goodwill and have come to the conclusion that the market capitalisation of the company should be much lower than the stock market says. The second is often nothing to do with the health or valuation of the company but is as an insurance; let's say they own Shell, BP and Exxon and they want an insurance that will payout big time if the oil price crashes for example. By borrowing a million or two shares they know that they will be in for a profit on one investment and a loss on the other. If they get their maths right they have sufficiently hedged their bet.. er investment I mean.
My valuation is lower than the market - how can I still make money?
Looking at that first scenario in more depth, the ultimate aim of every shorter would be to destroy the company. Possibly with similar morals to Richard Gere in Pretty Woman where his character would buy a company, sack as many people as possible then sell off parts of the company for more that they had paid for it. Some successful companies like Hanson Trust have worked that way in real life. The argument is that the old board wasn't using the capital effectively and the acquirer has just speeded up the process by taking the company to pieces. Most of us as investors are capitalists and should agree that this keeps company boards on their toes and is good for the country in which they declare their profits.
Shorting a company is not quite the same. You are of course putting pressure on the company board to say "we don't think your strategy will work" but you're not represented on the board like an activist investor might be. As such you're a passenger in the journey. At least an activist is trying to do something about the company strategy. If I short a Tullow share at £1, I'm effectively borrowing your share and paying a small percentage to your broker to lend it to me. I'm hoping that when it hits 90p or 80p I can buy it back and make a tidy profit. This could be far more than 10% or 20% profit as I only have to deposit a certain amount of money in my margin account. As such the maths works in a similar way to buying 10 houses that you mortgage and let out. You hold the risk, but you get potentially massive rewards.
What then happens if the share price goes to £1.10 or £1.20? Well, apart from running a risk in the trouser department you could ride it out or pay the extra 10p or 20p to buy the shares back. So, you've lost a 100k, no biggie, your hedge fund has squillions and will forgive you this time.
When would you short a company? Ideally when the difference between your valuation and the market is massively out of line, or if they're a retailer of course. A bit like buying shares in reverse, your potential gains will be highest when the market capitalisation is highest.
When wouldn't you short a company? As Sun Tzu would say (oh no we're going there are we?), when you face an army if you can pick your high ground you will improve your chances of winning (or something like that). Well it worked for Wellington outside a small Belgian village. How would that translate into shorting a company? It could probably be defined as a ratio of the current marcap divided by what you think they are worth. The higher the figure and the more you should short them. E.g. they are valued at £1bn, you think they're only worth £500m, so that's a ratio of 2.
Another example would be where the company is heavily indebted. Capital intensive companies like miners, oil and gas, house builders, construction companies have a cycle of investing for a year or three followed by small revenue, followed by hopefully breaking even, followed by profits. If they get the balance wrong, borrow money and invest in too many speculative ventures they leave themselves vulnerable to attack. At this point, a bit like the retailer with large debts and a pension fund with a deficit they might actually be worth zero. And of course if you divide a marcap by zero, you get a very high ratio to attract short interest.
I'm insuring my hedge fund against calamity. Would you like to invest in the nailed on profits fund?
Now this second reason for shorting may be a bit harder to get your head around. I should imagine we all understand the concept of insuring; we might do it for our crops if we're farmers, our lives if we have dependents and our cars if we're law abiding. But is it possible to insure your money? Let's say you have a small fund that you mange of £600m, you will be out of a job if that goes down by £100m, but if it goes up by £100m you'll just be asked to do it again next year. If might be better to settle for a rise of £50m by taking lower risks, or hedging your risks.
As such the concept is that you still make the same investment decisions that would have generated £100m of profit in the above scenario, but this time you come up with the oppositite scenario and think how to profit from that. As such a fund manager may be long on banks but short banks or be long on oil producers but short oil producers. In this scenario they probably don't want the company to fail, but they don't mind if it does.
I should add, that there are all sorts of financial instruments with which to insure your £600m pot. Some are riskier than others, and unlike just buying a bond or an equity they often have unlimited downside. For example borrowing someone elses shares with a commitment to buy them back eventually has an unlimited downside if the share price doubles, trebles etc.
So what's all this got to do with Tullow and why should I care?
I've always been interested in psychology, and am strictly an amateur dabler. This might partly be because if I can work out how people think then I can profit from that as an investor. I think we all do it, and some of the great investors are probably just that bit cleverer at it than the rest of us mortals.
There is a concept of confirmation bias. As investors, we've probably all woken up one morning and said why do I own xyz shares? For example back in late 2019, you might have decided that Tullow was over valued and shorted the stock. When the pandemic came along you thought Santa had arrived early so you shorted some more. Then you sat back and counted your profits. With confirmation bias, as the market changed around you, you found new reasons to back up your short position. As vaccines were produced, as the oil price surged, as the stock market recovered you were in your happy place as a successful city investor; Conan the destroyer of companies.
Occassionally you had contrary thoughts; what if the market has turned? As humans we can find it stressful to hold two opinions about a single topic. This is the concept of cognitive dissonance. As an investor this can be your enemy, if you hold something today because you held it last week, last month and last year, then it's possible that your brain is finding reasons to back up your strategy. Your brain will try to find the least stress and avoid the painful truth that what was right last year may be wrong this year. A good question to ask yourself is "would I open this position today?" If the answer is no, then you should probably close your position.
Help, I think I may have made a mistake and have borrowed millions of Tullow Shares
You may have heard that there's an OPEC+ meeting. It sounds like they are showing that they are good global citizens and are considering taking a less agressive stance to production cuts. It seems to be what is pushing the oil price back from $66 to $64 today. Although they are allegedly* an untrustworthy nest of vipers, they all tend to have one common interest which is getting Saudi to reduce production to keep the OP high (apart from Russia that is who just tend to open the taps). * is it ok to slander groups of countries?
Cripes, Tullow's banks seem to have approved their strategic plan. Well that's ok, they've got massive repayments to make on their bonds. I don't believe it when the board says they've got enough cash at an oil price of $50 to finance all of their activities. I will keep telling myself that; also must read that book my wife bought me on confirmation bias; what the heck is that anyway?
Why does this share price keep going up? I feel sick. I don't look forward to the Monday zoom meeting anymore. I'm sure this oil resurgence is just a storm in a tea cup, it can't last.. can it?
Wait.. what happened to the Short hares and the Tullow the Tortoise? Look at the share price as it nibbles its way forward whilst the shorts daydream about massive profits in the sunshine. It might take us a while, but something tells me we've got logic on our side.
Thanks for reading, I've enjoyed writing (it's probably therapy). Please remember to do your own research. This is not investment advice; goaaannn keep that short open. Borrow more!! I own shares in Tullow Oil, and have just increased my investment by 16% today at 45p. They don't come around like this that often. (that's not advice of course).
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