The Hedge Fund Industry's Biggest Shorts

By Maxwell Fisher - June 7, 2012 | Tickers: AMZN, XOM, INTC, IBM, JNJ | 0 Comments

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Hedge funds are widely criticized for opaque reporting and for charging high fees. Based on their largest short positions, they should be criticized for a lack of sense, too. Investors should consider buying a few of the stocks hedge funds are shorting the most and thank them for subsidizing investments in these solid stock picks.

The Hedge Fund Industry's Biggest Shorts

Goldman Sachs compiled the largest hedge fund short positions. This research listed the five most-shorted stocks as Amazon (NASDAQ: AMZN), Johnson & Johnson (NYSE: JNJ), Exxon Mobil (NYSE: XOM), Intel (NASDAQ: INTC), and IBM (NYSE: IBM). Have hedge fund managers lost their minds?

To be fair, this list is more of a demonstration of the mediocrity of averages more than a reflection of insider information or impending doom for any of these stocks. It should come as no surprise that large cap stocks such as these would be the top picks of a crowd, either as short or long plays. In this case the crowd was composed of hedge fund managers and these particular large cap stocks happened to attract the most attention from short sellers.

Topping this list is not much of a black mark for a stock, and investors should ignore this list as an essentially meaningless negative-popularity contest. This conclusion may seem ridiculous, but it is consistent with lackluster skill consistently found in active managers and the fundamentals of the stock picks themselves.

Be Skeptical of Hedge Fund Managers

Somehow laypeople assume that professions contain skilled practitioners. Certainly, an employed journeyman baker is more skilled at producing delicious goodies from the oven than untrained and inexperience laypeople. A chess grandmaster is a much better player than someone who has just learned the rules of the game.

When people think of skill or expertise they think of abilities and training that can produce results on command. The world's greatest chess player will produce winning games, some draws, and rare losses even against other grandmasters. Results like these are determined in tournaments which last days or at most weeks. The results of a master pastry chef would take at most days to produce. These are acceptable turn-around times with win/loss ratios that reveal themselves with very little data.

Stock picking is not like this. It takes years for skill to be distinguished from the randomness of the markets. Stock picking is more like professional blackjack. It takes many, many hands for there to be a sizeable skill difference between winners and losers. Moreover, many success stories are driven by luck instead of skill, which means that many successful hedge fund managers are not skilled investors, just fortunate. Thus, the aggregation of their short picks is not terribly condemning and should be taken with a grain of salt.

Worse yet, the returns of hedge funds may, in aggregate, lag passive indexes. This phenomenon is observed in the performance of actively-managed mutual funds, which have lagged passively constructed funds net of fees. It is currently impossible to know if hedge funds have historically produced a similar performance shortfall since, until recently, hedge funds were not required to report to the SEC. This allowed laggards to avoid shame and hedge fund return averages underrepresented losing funds, inflating return estimates and making them unreliable. If hedge funds have underperformed the broad market, they would represent an absurd category of "dumb money" investors. As such, their shorts might embody an ironic endorsement.

Investigating These Shorts

Aside for large market capitalizations, there are no fundamental metrics which are shared by these stocks:

Shares of Amazon.com are clearly pricey, and are trading above reasonable valuation multiples. Shares of IBM and Johnson & Johnson are reasonably priced, though they do not inspire investors to pick IBM on a valuation basis.

The remaining two hedge fund shorts, Intel and Exxon Mobil are actually attractively valued. Negative attention to these stocks in the hedge fund world may be based on negative views of the traditional PC market and conventional oil firms. Are these structural headwinds which will turn these value investments into value traps?

Questions about oil reserves and the disruption to energy markets posed by natural gas fracking may seem like serious issues for big energy companies like Exxon Mobil. On the contrary, natural gas from "fracking" has not yet substantially replaced gasoline, diesel, or jet fuel as a fuel. At a single digit P/E, these are acceptable risks.

Intel is another company which may face structural headwinds. Analysts fear the shakeup in the PC market caused by mobile devices. Regardless, people still buy laptops and desktops, and as a chipmaker Intel will have markets for its products, regardless of device format.

Stories attract human interest, but they make for lousy investments. Instead, long-term investors should always keep the value effect in mind. The value effect is the historical outperformance of low-valuation stocks relative to high valuation stocks. The cheap stocks were cheap because their outlooks were dire, yet the market overreacted. It's easy to see this in retrospect; it is much harder to be so dispassionate in the moment.

Investors should thank hedge funds for short-selling Intel and Exxon Mobil, thereby reducing prices and effectively subsidizing their investment in these two value companies. Each of these firms is trading at attractive price multiples, pays a juicy dividend, and is a compelling pick for a long-term portfolio.

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