Two people, whose opinions I respect very much, independently made the following claim to me recently: “The great frauds of the late 1990s/early 2000s (Enron, MCI-Worldcom, Lernout Hauspie, etc) are a thing of the past… those types of frauds are likely never to happen ever again.” My gut reaction to their belief was that they are wrong, and I told them as much (isn’t it ironic these two made this claim, just as US markets hit all time highs?). Rather than relying on my instincts, however, I decided to look into the evidence.
To sum it up: the evidence does not support their opinion. Look no further then the fraud implosions of the 2006-2008 period as proof that falsifies the belief that the late 1990s/early 2000s somehow marked the end of the great frauds (not to mention, there have been some more recent frauds as well).
Some of you may wonder, “So what? That’s all in the past.” Others will wonder, “Why? Why didn’t Sarbanes Oxley, etc. prevent some of the fraud-driven implosions from occurring in 2006-2008?” I will not discuss the “why” question, but I will express the following opinion:
I believe we’re entering a period where we will see a wave of some truly great fraud implosions (like we did in the late 1990s/early 2000s), within the next few years.
The following is a summary of my research (I tend to focus on how to monetize via single names, which I do not cover in this post):
- Macro Matters - Frauds seem to unravel (come to an end) in cycles, usually clustering around market corrections/crashes. We’re due for a correction, and the faster and higher we go, the greater the risk of a disruptive crash.
- Short Sellers, Whistleblowers, and Regulators Matter - Frauds are less macro dependent when (1) regulators do their job (i.e. enforce existing rules) (2) short sellers speak out & are taken seriously, and (3) whistle-blowers act . When short sellers/regulators/whistleblowers win, absolute return investors/speculators win as well, as fraud stocks decouple from the overall market.
- Poor Regulation/Enforcement Increases the Frauds’ Correlation to Macro - Frauds seem to become pro-cyclical when regulators are complacent, incompetent, or (in some cases) corrupt. In these cases, frauds grow larger and last longer than they otherwise would/should have. Adds to market instability, volatility, and reduction of confidence.
- The Short Sellers’ Pain, is No One’s Gain - Going long highly shorted stocks has been a very fashionable trade since Q4 2012. Yet history clearly shows that “get shorty” is not the path to long-term prosperity… “get shorty” almost always precedes market corrections/crashes (the sole exception to this seems the beginning of a secular/structural, multi-year bull market; and if you believe we are entering one, I encourage you to express your views accordingly). If you try to get shorty, the market will get you. And then some.
- Vilification of Short Selling and Free Speech Precede Market Turbulence - If you think it through very carefully, short selling is a form of free speech (a subset, if you will). The ridiculous and absurd vilification of Rocker Partners by Overstock.com/Patrick Byrne, and Greenlight Capital by Allied Capital and the SEC… well, those things occurred 1-2 years before some serious market volatility. If you think “this time is different” … time will tell.
What Investors/Speculators Should Do
- Limited Partner types (Endowments, family offices, pension funds, etc) should start adding exposure to funds with short selling expertise… there aren’t that many out there. This can come in form of net short/short only, long/short, volatility, credit, event-driven, special situation, opportunity, and even macro vehicles. The key is finding a fund that has a natural short seller on board (short sellers are probably born, not made; many famous short sellers have said as much). Even better if the person at the top (the head PM/CIO) is a short seller, who has subsequently branched to do other things. Those who tout AMZN as shorts are to be avoided…as they’re not short sellers (a red flag). They are closet value, long-only guys looking to “learn” how to short (at your expense), and justify 2 and 20 compensation structure.
- General Partner types (hedge funds and family offices) - Most professionals in the hedge fund world are blessed with not possessing the short seller “gene”. You might want to start looking to add someone who does though. You will likely have to throw out your normal hiring criterion: most of the great short sellers have very… non-traditional backgrounds, especially on paper. A few look kinda, sorta normal on paper, but the vast majority don’t. Just take a look at the Feshbach Brothers, Citron Research, Muddy Waters Research, and many others, to see what I mean.
- Do your own homework, and/or spend the necessary $ and time resources. There’s a fine line between being cheap, and being stupid. You buy insurance when you (think) you don’t need it. You’re smart to buy insurance when it’s cheap (when valuations of the lying are higher, not lower). Compare buying index options, short ETFs, vs. paying a short seller with an inverted 2/20 structure (see Kynikos). You’ll find that it’s actually cheaper and more effective (in the case of short selling, not all hedge funds) to pay a short seller, rather than do it yourself.
- Be a risk manager, not a career risk manager. Investors seem to, time and time again, buy insurance at market lows, and sell insurance at market highs. The ever trend-following types, added short exposure in late 2008/early 2009, not 2006/2007. In 2001/2002, not 1999/2000. You don’t have to follow the crowd, if your goal is capital preservation AND enhancement.
- Consider reducing exposure to funds that have performed exceptionally well the last few years.
On a lighter note: word on the street is that women make just as good (if not better), short sellers as men.
::UPDATED:: 2013 05 29
Here are a few things that contextualize why I believe that history is doomed to rhyme:
(1) “Covenant-lite” loans have soared to more than 50% of all loan issuance so far this year, twice the level seen during 2007”
(2) SEC accounting focus returning - “Congress also added to the SEC’s responsibilities when it passed Dodd Frank. So Congress both gave the SEC more to do and fewer resources.” -
http://online.wsj.com/article/SB10001424127887324125504578509241215284044.html#articleTabs%3Darticle
(3) Harvard study shows high levels of cheating (i.e. bad behavior is omnipresent wherever there is “pressure, opportunity, and rationalization” - the fraud triangle… Harvard isn’t the problem; it’s merely a microcosm) http://www.thecrimson.com/article/2013/5/28/senior-survey-2013/?page=single#
(4) Free speech and media under threat ( and a badboy from the Allied Capital days holds position of power) -
U.S. Attorney in Phone Leaks Has Seen Both Sides - http://www.nytimes.com/2013/05/21/business/us-attorney-in-phone-leaks-has-seen-both-sides.html?pagewanted=all
Leak Inquiries Show How Wide a Net U.S. Cast - http://www.nytimes.com/2013/05/26/us/leaks-inquiries-show-how-wide-a-net-is-cast.html?pagewanted=1&_r=0&adxnnlx=1369505313-YF0G3tpKU8tum4wASCh6yA
Press Sees Chilling Effect in Justice Department Inquiries - http://www.nytimes.com/2013/05/25/us/politics/reporters-see-chilling-effect-from-justice-dept-inquiries.html?hp&_r=1&
(5) Skyscrapers…gotta love them skyscrapers - http://www.businessinsider.com/skyscrapers-that-predicted-financial-crises-2013-5?op=1
