Letters

Short Investing

January 2022

Short Investing

We have an opportunity to generate material profits from our short investments over the next few years. This should be additive to our long performance. Last year we generated profits on our short book, even in
the face of rising markets. That has continued in 2022, although helped by more volatile markets.

This month we want to give you more detail about our short investment process. We focus mostly on four types of short opportunities:

  • Companies being disrupted: businesses whose value proposition ceases to be attractive to their clients
    due to the emergence of innovative alternatives
  • Stock promotions: companies sold to the public through IPOs, SPACs or direct listings with rosy
    projections backed by promotional management teams eager to cash-in on their holdings
  • Fads: businesses that benefit from exponential success and growth during a season but fail to sustain
    it once the novelty effect wears off
  • Frauds: accounting fraud, representation fraud and any other form of misrepresentation made by
    previous holders and management to inflate the company stock above its inherent value.

The opportunity set today is larger than when Somar got started. Fig. 1 shows the acceleration in adoption of new technologies that reduces the runway for incumbents to defend their business.

Fig 1.
Sources: Census Bureau, Consumer Electronics Association, National Cable and Telecommunications Association, Facebook, Apple

Below, Figure 2 shows the increase in recent listings, including SPACs. 

Fig 2.
Sources: Statista, Reuters, Dealogic

Our method for identifying, conducting due diligence, and executing on these opportunities varies by type of short. In this letter we will give a summary overview of each. If you wish to discuss this in more detail,
please reach out to us.

Companies being disrupted are normally identified through the course of our cluster analysis. We identify innovative companies that can offer a significant improvement in the customer value proposition and study whether the incumbent can close the gap. If not, the incumbent becomes a potential short candidate. We estimate what it would take for the incumbent to disrupt itself, and whether the board and management team have the track record necessary to conduct such a big pivot. We investigate channel partners and customers to gauge their satisfaction and willingness to change. If both the pivot strategy and the milking the status quo strategy leads to significantly (20%+) lower inherent value than the market is ascribing, we get interested in the short opportunity. This analysis considers the speed of decline and cash generation and capital deployment abilities of the management team to ensure the thesis plays out in the next 6 to 9 months.

Stock promotions like IPOs, SPACs and direct listings cross our desk when these sales are launched to the public. We study them with an open mind as some could be long opportunities, but most will turn out to either
be a pass or a short opportunity. The starting point is the incentive structure of the management team and the stock sellers. We also investigate the business plan of the companies and through field work assess whether their promises are conservative or over ambitious. Importantly, we look for a long-term competitive advantage. Is this the first company of many that will claim to own a particular hot sector (AI, Blockchain, …)? Or is their position unique that they will have limited competition even when their sector matures? Interviews with venture-backed challengers are a very helpful tool here. Finally, we investigate management’s track record and motivations: are they missionaries, builders? Or are they salespeople mostly motivated to cash-in? The enthusiasm around these aspirations can lead to significant overpricing of mediocre assets opening good short opportunities.

Fad candidates are new products or services that surged into the mainstream zeitgeist in a short period of time. Some of these will turn out to be the next iPhones, Google or Instagram. Most will fade. To winnow the
wheat from chaff, we investigate the market penetration and the difference between sell-in to the channel and sell-through to final customers to get early reads into sales inflections. Field observations and social
media engagement are also good clues for potential fads. Once one has been identified, our valuation analysis will inform us whether there is still downside for the short investment or whether we were too late in spotting that particular opportunity. Timing and agility are of the essence in this type of opportunity.

Frauds may be the most exciting type of opportunity on the short side. We identify these based on exposés by either investigative journalists, former employees, or activist short sellers. We aim to duplicate their analysis to confirm the assertions and accusations. A careful analysis is made of the character of the management and employees involved in the fraud, including interviews with former colleagues. Finally, we estimate the inherent value of the company after accounting for the fraud impact. If the difference to the current price is material (20%+), we get interested.

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There are strong connections between our short work and our long work. Many times, our work on one long opportunity leads us into a short opportunity and vice-versa. The short work also makes us better sellers in
our long book. By forcing us to invert our mindset it allows us to see potential negative trends earlier than we otherwise would have. Most importantly, we believe our short investments can continue to be a source of positive profits for many years.

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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. 

Photo by Susanne Jutzeler from Pexels

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