04
Jun
2020

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Why shorting pie in the sky is dangerous

We often hear market pundits comment on expensive stocks that currently make no money, labelling them as “great shorts.” The Teslas, Pelotons, and Snaps of the world are examples of this that are recognisable to most. But are they in fact great shorts? We recognise the temptation to short loss-making businesses with valuations that are impossibly rosy, but there are a number of considerations for these types of shorts that give us pause.

While overvaluation is a necessary component to a great short, it alone is insufficient to tilt the likelihood of the short position working out in your favour. When combined with a business that has high growth and uncertain future economics, a high valuation might provide a blanket of comfort, but is in our view insufficient to protect the short seller from damaging losses.

Let’s consider Snap Inc. (NYSE: SNAP), the parent company of the photo app that’s popular amongst millennials. SNAP has never turned a profit. In fact, it has been deeply loss-making, incurring a loss of almost $1 billion in fiscal year 2019. Despite this, the stock has an almost $28 billion market capitalisation, which equates to an over 13x price/sales ratio. Said another way, the business would need to produce the same level of revenues, but with no costs for 13 years just for you to get your money back.

However, SNAP’s revenues are growing rapidly, and investors are not banking on the revenues remaining static. Rather, the seemingly large valuation is predicated on continued strong revenue growth (which has been above 40 per cent per annum over the last two years) and operating leverage. In other words, the growth will drive SNAP towards a radically different, and profitable, margin structure in the future. This provides some context around the setup for short sellers who are shorting a business such as SNAP. So why is this dangerous?

One of the biggest issues for short sellers of these types of businesses is the mismatch between the investment horizon of bullish investors who own SNAP, and the timeline for when data is likely to emerge that supports the investment theses of bearish investors. Let’s break this down. Bullish SNAP investors are likely basing their views on their own data and financial models. But who’s to say that they’re wrong?

This would require data about the likely future margin structure of the business that simply doesn’t exist – SNAP is a unique business in a high growth phase, and no one knows exactly what the long-term margin potential is. There are a number of data points we would need views around, in terms of their future potential and trajectory, which are in a lot of cases unknowable.

For example, what will the daily average user (DAU) growth be in each of the regions going forward, and how much of the global population will be using the Snap app in the future? What is the potential average revenue per user (ARPU) uplift coming from the recent shift to direct advertising formats, and to what extent can SNAP make inroads in bridging the ARPU gap with other digital ad platforms? What will the future operating expense growth look like and what ramifications does this have for future margins? These are enormously difficult questions to answer due to the rapid pace of growth and change at SNAP.

To get greater clarity around what the long-term economics could look like would require waiting, perhaps for many years. A short seller is not afforded this luxury, and as the business grows strongly, the lack of compelling data to disprove the investment theses of those with a positive view on SNAP helps these same investors suspend disbelief and can drive the stock higher. This can be very dangerous for short sellers, and can see an expensive stock turn into an even more expensive stock.

Part of this danger is rooted in the high growth nature of a business such as SNAP, and the compounding nature of this growth. High growth, and variations in this growth rate both upward and downward, can dramatically change the future financial position of SNAP. The corollary of this is that the compounding effect of this high growth widens the possible future outcomes for the business, and thus creates an enormously wide valuation range. Combined with the above mentioned uncertainty around SNAP’s future economics, it’s difficult to say with confidence whether SNAP is worth $5 or $50.

Investors might have a view that SNAP is expensive and poorly positioned but it could take years for these views to play out. The danger of shorting these pie in the sky stocks is the immense damage that can be done in the interim from bullish investors having a set of conditions that allows them to remain bullish.

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