Letters

The Short Game

July 2021

The Short Game

The Short Game
In the last year we have focused on significantly upgrading our short book and our short investment process. We are seeing good early results. We are getting more and more ideas that return more than 10%, which means the stock declines 10% or more from the average price at which we shorted it.
While we are pleased with the progress, we are not satisfied and continue to work hard to build further improvements into our process. Meanwhile, I would like to update you on our progress so far. Let’s look at improvements we made in each step of the investment process.

We diversified the sources of short ideas beyond market share losers to upcoming disruptor entrepreneurial companies. We are now spending considerable time and effort finding opportunities with weak firms and firms with dishonest management. This includes firms in precarious financial and strategic positions, with management that make exaggerated claims, with suspicious financial statements, and with management teams with a track record of running pump and dump schemes or even failing companies.

Our due diligence continues to focus on finding as many data points as possible to refute or to confirm our short thesis. However, we are now even more ruthless at prioritizing resources when ideas have an impending catalyst. We make sure we drop everything that is not urgent and focus on due diligence of a short idea whose catalyst may come sooner rather than later. As we like to say in the office, we are analysts not reporters. We don’t work understanding what already happened. We work to understand and gain conviction on what will happen.

Our portfolio construction process continues to improve and has shown considerable improvement. We build a short book with a diversity of themes and types of ideas. We don’t’ want our short book to be concentrated in specific industries or types of theses, like for example, incumbent players that are slowly losing share to fast growing disruptive companies. While there is a space in our short book for selective shorts like these, we recognize that there are times when investors take refuge into larger market cap blue chips. Perversely, that tends to happen during periods of market distress. These are times when we expect our short book to protect our downside so we can aggressively pursue long investments that may be selling at bargain prices.

Risk Management is crucial in short selling. Every short has a potential maximum upside of 100% while exposing investors to unlimited potential downside. We need to control the position size of each short investment to mitigate big losses in one position, such as the ones that hit some Hedge Funds earlier this year due to the meme stock phenomenon. While painful, at times it may be prudent to exit a short position despite its losses, for example if there is a high risk that a short squeeze is in motion. With patience, better entry points will present themselves. This discipline enabled Somar to avoid major losses when some stocks rose abruptly driven by mostly retail investors coordinating through social media.

We have also been extremely disciplined harvesting positions quickly when a catalyst brings the price of one of our shorts close to our target. We will not wait for the full target to be reached if the catalyst has already played out. This allows us to put those gains “in the bank” and relocate the capital to the long list of ideas we have.

All these improvements and early results bode very well for the prospects of our short book going forward. They are structural changes to the way we work, and the results show a lot of promise. We are not done yet. At Somar we have a continuous improvement mentality and I’m sure in a future letter we will be updating you on additional improvements and additional upgrades to our short returns.

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It is very unlikely that we will write about a short position in a letter. We are happier to talk it through with you over one-on-one conversations. The reason is that we don’t want to corner ourselves into a written thesis and supercharge the human bias to find confirmatory evidence and defend our public positions consistently even in the face of new evidence that questions our initial thesis.

Finally, as we’ve seen earlier this year, publication of short thesis may invite market participants to pile into the stock to squeeze the shorts out.

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Disclaimer: This website is for general information purposes only and is not intended to be, nor should it be construed as investment advice, nor a solicitation or offer to buy or sell any securities, related financial instruments, or  interests in the Somar Master Fund, LP (the “Fund”) or its feeder funds. The information contained herein is not complete, and does not contain certain material information such as disclosures and risk factors about the Fund or its feeder funds. Opinions expressed are current opinions as of the date of this material only and are subject to change without notice. Hedge funds: (1) often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; (2) can be highly illiquid; (3) are not required to provide periodic pricing or valuation information to investors; (4) may involve complex tax structures and delays in distributing important tax information; (5) are not subject to the same regulatory requirements as mutual funds; and (6) often charge high fees. 

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