AFR: Four tips from hedge fund pro David Allen

Click here to read this article on The Australian Financial Review website. 

Shorting stocks is not for the faint-hearted.

The practice, which is deployed by hedge funds to profit from falling share prices, is equally maligned and obsessed over. And short sellers are inherently losers in a market that tends to head up, rather than down.

Adding to the high-risk, high-reward dynamic – unlike traditional “long” investing – if a shorted stock halves in value, the short sellers make 50 per cent; if it doubles, they lose 100 per cent.

And with sharemarkets in Australia and overseas charting record highs this year, it’s been a tough assignment for many hedge funds. Last month, John Hempton, one of the country’s highest-profile hedge fund operators, told investors in his Bronte Capital that he was reviewing his strategy after the firm recorded its worst monthly returns in more than two years.

The culprit? The rally in global markets had hit the firm’s short book, hard.

Not all short-sellers are in a world of pain. Take Sydney’s Plato Investment Management, where the firm’s long-short strategies are helmed by David Allen.

Allen’s Global Alpha Fund is up 36 per cent in the past 12 months, putting its return around 19 per cent a year on average since launching in September 2021. Around 70 per cent of the fund’s outperformance in that time is attributable to its short book.

Allen’s approach is largely quantitative and builds on his 15 years researching long-short models at JPMorgan in London before returning to Sydney to join Plato in 2018. Underpinning the strategy is what Allen call his “red flags” system, which the fund runs on thousands of companies a day.

“Eight or more red flags on a stock and on average, it underperforms the benchmark by 20 per cent over the next 12 months,” Allen tells The Australian Financial Review.

It isn’t as easy it looks

 

Allen’s approach is ultimately fundamental, looking at companies on an individual level rather than relying on macroeconomic factors.

That runs counter to much of the public perception around shorting, where some managers have made careers and fortunes betting on a macro idea.

That approach was made famous by Scion Capital’s Michael Burry – played by Christian Bale in the 2015 film The Big Short – who bet against US mortgage-backed derivatives leading into the global financial crisis of 2008.

In Allen’s experience, however, this kind of top-level call isn’t how his fund found its edge.

“The macro and the geopolitical make for amazing dinner table conversation, but it doesn’t make you more money,” he says. “We stay away from making those sorts of predictions and we stick to what we’re good at, which is picking winners and losers.”

Likewise, when asked about particular themes or styles in the portfolio, Allen is uninterested in trying to time the market.

“We spent eight years at JPMorgan trying to build a style timing model, it was like the Holy Grail,” he says.

 

“After eight years, we gave up.”

Macro does have its place in Allen’s approach, but only in managing the kind of risk inherent in a portfolio that can range up to 1000 stocks.

“Where we do perform that human hand on the tiller is much more on reducing risk,” he said.

“That’s for if we notice that we’ve got a big exposure to something like if suddenly Harris wins in November, or if we’re worried about what’s happening in the Middle East.” To manage that risk, Allen says the fund runs 82 different stress tests across every day.

Pay attention to who’s trading

Three years after launching the fund, Allen is still tinkering with the red flags model to better highlight the next great shorting opportunity. He’s adding new flags frequently.

“One of the most interesting ones that we’ve added recently is options data. Most fund managers don’t really look at that particularly closely,” he says.

“If the stock looks fine, but suddenly, you notice that huge demand on the put side relative to the call side, then people may know something, it’s a simple signal that works really well.”

Insider transactions are another factor in the model – and one likely familiar to investors – but Allen notes that deciphering the signal from the noise can be tricky.

“When you actually do the research, most of those transactions are not informative at all about the future stock price direction or earnings,” he says.

“You might be selling stock because of a tax bill, or because your options are just vested or you’re getting divorced.”

But when relevant, such transactions can be very telling.

“The only ones that are really informative are when the stock price has been hammered and then they’re selling a lot … those types of red flags can be pretty powerful,” he said, pointing to lithium miner Liontown Resources as a recent example from the fund’s short book.

“The company had 12 red flags already and then in December last year, the CEO sold a million dollars worth of stock after the stock had fallen 50 per cent from its peak. That was a big driver of confidence in our Liontown short.”

Small signals, big shorts

 

Other indicators in Allen’s model might be overlooked if investors rely only on a company’s financial reporting. For instance, while company culture isn’t something closely watched by investors, Allen says it’s proven a strong signal for some of the ASX’s most notable downfalls.

“One of the ways that we’ve looked to capture culture is using online employee reviews which include employee morale and satisfaction with senior management,” he says.

“No surprises, Qantas, before their trouble started, had a horrendous rate – Cettire as well,” he said, adding that the firm hadn’t shorted the latter but had exited an investment when several red flags accumulated.

“We were long Cettire and the red flags kept piling up. Eventually, we said it just looked a bit too good to be true and sold out despite the share price strength at the time.”

While none of these factors alone may constitute a strong enough indicator to short the stock, combined over time, they can be illuminating. Even things as seemingly innocuous as the tenure of the company’s auditor allow insight into a share price’s likely trajectory.

“Best practice is to rotate the partner every five years and the firm every 10 years,” he says. “Lendlease is a name we’ve been short for a long time. The last time they rotated the firm doing their auditing? 66 years.”

Don’t get greedy

 

Even when a short pays off, Allen remains wary of how quickly the conditions can sour when the asymmetries turn on the short seller.

“The shorts that can lose you the most money are the ones that have made you the most,” he says, noting that once a short has performed well it can be tempting to double down at the wrong time.

“Stocks that are 80 or 90 per cent down, they can get just a little bit of good news and then double or triple,” he says.

Earlier in his career, he saw this first hand. “A stock that’s gone from $10 down to $1 can then jump back to $3, yeah. If you reloaded that short position, you’ve lost more than you ever made,” he says.

“We have a hard rule, if a name is 70 per cent off its peak, we’ll never add to that short. If it goes 80 per cent off its peak, we’ll always close it.”

Written by Joshua Peach. Originally published in The Australian Financial Review on 4 November, 2024.