We Need Genuine Short Sellers, Not Imposters.
Shorting and buying technology stocks are two sides of the same coin. They speak each other's language. The majority of self-proclaimed short sellers are neither. They are financial market harlequins.
Genuine short sellers are vital to the financial markets. Their role is to provide liquidity and keep the innate optimism of investors in check. Ironically, in the technology sector, the best short sellers are also the best investors. In other words, buying or shorting innovation requires the same type of work. The only difference is the inverted payoff. Longs make money on the up and shorts on the down. And it’s precisely because of this inverted payoff that short selling technology is much harder. Therefore, shorting should be reserved for only the smartest investors on Wall Street. Unfortunately, that’s not what’s happening. Instead of active short sellers, who put their money on the line to support an investment thesis, markets are littered with eloquent imposters who make a living constructing catchy one liners devoid of substance or value. These merchants of doom make a living spreading fear and doubt among investors. Their newsletters, tweets, and so called research reports are optimized for virality. In this increasingly distorted world of clickbait finance, money is not made by investing but by spreading entertaining narratives. Most short sellers are storytellers, not investors. That’s a problem because financial markets would be better off with a class of professional short sellers who do the work, risk their own money, and provide valuable perspective on investing in equities.
When we started Orange Capital Partners in 2008, our aim was to invest both long and short. It served us well towards the end of 2008, when the markets collapsed. But over time, the short selling became a drag on our performance. More importantly, it also turned into a psychological nuisance. You’d do all the work, analyze the negative factors about a company, put on a short, and then keep waiting until one day the company actually collapses. The demise of companies is typically slow until it accelerates. Then it goes fast. In the meantime, you are up against a slew of investors, managers, and stakeholders who want the stock to go up, not down. Short selling is a miserable existence, to say the least. But the most damaging thing about short selling is the timing. We had several good short ideas, such as Deutsche Bank or Brazil Foods. In both cases, we closed our shorts at their respective highs only to see them collapse subsequently for the exact reasons we put the shorts on in the first place. Short selling is hard. That is most likely the primary reason for the market's scarcity of active short sellers. Another problem with short selling is the interference of central banks and their propensity to pick winners or losers. In Europe and Japan, many financial services companies are zombie-banks kept alive by their respective central banks. That’s another hard nut to crack for short sellers.
The majority of short sellers are imposters
The result of all this is a new type of cottage industry of "pseudo investors" impersonating short sellers. People like Jim Chanos, David Einhorn, or the team behind Citron are just the tip of the iceberg. Make no mistake, these are smart operators who make a good living by spreading negativity. They are not, however, short sellers; they are entertainers. In fact, they are what journalists should be: critical observers with lots of opinions but no skin in the game. In my opinion, that’s the key problem. Risk and investing are two sides of the same coin. They feed on each other. Whoever doesn’t feel the pinch of taking risk is not an investor. Most self-proclaimed short sellers don’t have risk and therefore are not investors. They’re entertainers. If you don’t run the risk of losing real money, you are not an investor. Then you’re just a storyteller. That applies to Chanos & Co. as much as it does to any other attention grabbing merchants of doom. Buying puts doesn’t count. If you buy puts on a company, you’re not short; you’re long puts. And if you buy puts on lots of different companies which happen to do new things with unproven business models, then you are gambling on innovation failing. That’s ok. You could argue that everything new eventually fails. Statistically, you’re probably right. But that’s not short-selling, and there is no value added in such trades. You’re just stating the obvious. Most new ideas fail. But every now and then, one of them creates amazing amounts of money for investors and customers. That’s why there is an active investor community buying the shares of innovative companies. If you want to be short innovation, fine, be short. But don’t gamble with puts and then pretend to be short.
Jim Chanos is a case in point. He’s been around for a long time. He made his money with fraud detection. In other words, he found companies that cheated and exposed them. That’s fantastic. However, this does not qualify him as an expert in technologically enabled innovation. This has nothing to do with fraud. There might be an occasional overlap, such as with FTX or Theranos. But innovators typically don’t start companies because they are crooks. They start businesses because they have an itch to scratch. Chanos is a hammer looking for nails. His nail is "whatever is new and unproven." Again, I am not against such a worldview. Just keep it as such—a world view, not an investment thesis. By definition, new things are novel. That means you can’t reason by analogy. If your argument against Tesla is that every car maker eventually ends up with low margins, you’re reasoning by analogy. It’s like saying retailers struggle to make money and then shorting Amazon against that thesis. Well, Amazon turned out to be more than a retailer. Amazon is Amazon. When Apple came up with a phone, you could have argued against the iPhone because the phone business is hopelessly competitive. To people like Chanos, I say, "There is an alternative to mediocrity; it’s called engineering!”
Another common fallacy amongst merchants of doom is the argument that something can’t happen because it has never happened before. Chanos loves to argue like that. Years ago, he suggested shorting Tesla because they needed to build factories to sell cars. "That's expensive," Chanos argued. "They're investing in factories to produce electric cars, when in fact there is no demand for them." "If you want to bet on electric cars", so Chanos, "just buy Ford or GM since they’ll figure out how to build them if there is actually demand. "As a result, according to Chanos, Tesla was a good short hundreds of dollars ago (split adjusted). To illustrate how myopic this point of view is, let’s imagine Jim Chanos analyzing the first oil discovery in Pennsylvania in 1859. He’d say something like, "Oil is a pipe dream. How can you invest in something like that? You need pipelines, refineries, and machines to make this work. But we don’t have them. If you want to bet on innovation in energy markets, buy shipping startups in Nantucket; they’re excellent at finding better whaling grounds to hunt whales. That’s the oil we actually use commercially. This new black stuff coming out of the ground is too expensive. It won’t work. We’re short.”
The status quo is not an investment thesis
The absurdity of this type of reasoning is exemplified by another merchant of doom with the appropriate name of Doomberg. To be fair, they don’t claim to be short-sellers. They’re actually honest about their role in financial media, since all they do is publish newsletters. But much like Chanos & Co., their argumentation suffers from chronic confirmation bias. Doomberg is on a mission to dismiss innovation in the energy sector and argue for the status quo of fossil fuels and nuclear power. While I agree with them on the dangers of climate change hysteria, I see the same flaws in their analytics as with Chanos. Doomberg is just a hammer looking for nails. For them, the nail is "sustainable energy." No matter where it comes from and what the technological potential is, if it's not fossil or nuclear, it’s not going to work, according to Doomberg. Here is an example. They argue that lithium-ion battery storage will not work because of all the metals required to build enough batteries for global energy storage. I am not sure if they really believe in statements like this or just make them up to attract subscribers. I wonder what Doomberg would have said in the 1950s, just after William Shockley invented the transistor. To illustrate my point, let’s play a little game. Imagine Doomberg publishing an article in the early 1950s commenting on the potential of transistor technology. Here is an excerpt from their hypothetical newsletter published in the early 1950s titled "The Lunacy of Transistor Technology." It goes something like this: "People say transistors could be used for computing and replacing vacuum tubes. One of Shockley’s engineers, Gordon Moore, recently gave an interview and, with a straight face, predicted that one day we will be able to store all the books ever written in digital form using transistor technology. Now, Mr. Moore has a degree from UC Berkeley, so we believe he knows his math. Let’s just do a preliminary calculation. To store this many books digitally using 1950s transistor technology, you’d need a computer the size of the distance from San Francisco to San Jose. And the energy required would be more than the US energy capacity of 1950." Doomberg would be right about that. With the processing and memory technology of the 1950s, storing books digitally would have been a logistical nightmare. However, the claim of digitally storing books does not seem so lofty in 2023. In fact, it's a reality. Thanks to Moore’s Law, Wright’s Law, and other dynamics associated with rapid innovation, processing and storage technology have advanced sufficiently enough to store books digitally. People like Doomberg and Chanos disregard future dynamics and argue as if the world was static. But these are educated people. Don’t they see how absurd their argumentation is? Or maybe they just play a character, like Steven Colbert used to impersonate a character in the Daily Show. I believe it’s the latter. Chanos is a modern-day financial market harlequin. His actual role is to thwart technologically enabled innovation.
But financial markets need more than splashy prose. Chanos, Einhorn and Doomberg are nothing more than echo chambers for like-minded anti-progressers. Real investors would be well served with short sellers who actually do the work, put money at risk, and actively try to counterbalance the innate optimism about innovation in financial markets. Why don’t we have them? The simple answer is that it is very hard to be short innovation. The risk is way too high and doesn’t pay enough. Who on earth wants to be short stocks like Apple, Amazon, Facebook, or Tesla? As a real short, you'd be bankrupt many times over. That’s the problem. So what you get instead is an army of merchants of doom throwing puts at the wall and hoping that something sticks. They have little or no skin in the game but make a good living touting negativity.
Shorting innovation requires the same type of work as buying it
In this essay, we argue that there is a place for true investors to professionally short innovation. Actually, shorting innovation is the same as buying it. They’re the two sides of the same coin and speak each other's languages. In other words, the work required to isolate short candidates is the exact same as identifying good long candidates. The key is to define what innovation actually is and expose those companies that claim to be innovators but aren’t. We define innovation as a process with rapid iteration coupled with an obsession to lower cost and increase customer value. That’s true innovation. You don’t want to be short something like that. Even if you think their founders are crazy—they often are—you don’t want that kind of risk. But everything else is ripe for shorting. One rule of thumb is to find companies that make lots of effort to advertise themselves as "true innovators." Advertising innovation is like explaining jokes. If you have to explain that it’s funny, it’s not a joke. The same applies to innovation. If you have to advertise your role as an innovator, you’re not an innovator. You’re an imposter. One example is Uber. The company has been sold to investors as an innovator that is changing the world of transportation. But in essence, Uber is an improved version of the legacy taxi cab business. The problem with Uber is that they are not lowering the total cost for customers. In fact, they are even increasing them. While prices, wait times, and other hassles are up, quality, comfort, and safety are down. Uber’s strategy has been to subsidize customers and get rid of competition. That’s why, for a while, customers were enjoying lower prices. But this strategy could not go on forever, so Uber had to raise prices back to reality. Today, we still have legacy taxis, buses, and light trains. Fortunately, local transport has not been fully uberized. Uber is not an innovator. Uber is a predator with some software attached to it. By the way, just because you use software in your business and hire people who know the difference between C and C++ doesn’t make you an innovator. Technology alone doesn’t suffice. The same applies to companies like Lyft, Doordash, Slack, Dropbox, or Instacard. And the list goes on and on. There are many more examples of companies that have built novel technology stacks and do interesting things but don’t actually iterate enough to evolve their own specific niche. There is too much competition in their markets. Those are good short candidates.
Innovation is engineering with value. True innovators create wealth by constantly iterating around engineering problems. Once one problem is solved, they generate new, better problems, which are solved through further iteration. The key differentiator between innovators and imposters is that the solutions they create actually add customer value, for which the latter are willing to pay. Customer validation is oxygen for innovators. Nobody understands this better than Elon Musk. He runs all his companies like that. When designing rocket launchers at Space X, they optimize for thrust per dollar. That’s a complete novelty in the space industry, which has always been financed by government money. Thrust per dollar means you not only deliver a rocket launcher with power, but you do it at a low cost, which is a key driver of customer adoption. Tesla is obsessively driving down costs while simultaneously increasing customer value. Another great example of a true innovator is Amazon. Jeff Bezos built the company on two pillars. Low cost and high customer satisfaction The word "innovation" doesn’t even appear in his shareholder letters. Innovation is not something you aim for. It’s a necessary tool to achieve your goals as an entrepreneur. In the words of Jim McKelvey, "Innovation is not a choice, it’s a necessity." You don’t want to be short this type of innovation. That’s like being short evolution. It’s like trying to prove Darwin wrong.
The best remedy for hype is engineering
Short-selling innovation can be an honorable endeavor. There are plenty of pseudo-innovators, con artists, and imposters who start companies under the premise of being true disruptors. They are great shorts. Some of them are fraudsters like FTX or Theranos, some are flirting with fraud, and many are just mediocre entrepreneurs with good intentions but insufficient skill and stamina to be true innovators. The key to innovation is not the technology but the process. This is a simple rule of innovation. True innovators don’t spend energy to advertise their "innovative genius." Instead, they obsess about engineering solutions to lower the total cost of ownership for customers. They might have some lofty goals such as "changing the retail industry" or "electrifying transport." But their day-to-day activity is plain old engineering, with a focus on lowering costs and increasing customer value. Just think of Space X and their obsession with "thrust per dollar." This is actually an important indicator for investors. When you listen to founders, consider whether they are optimizing for dollars spent. Tesla is optimizing for dollars per mile driven. In their DoJo AI computer, they’re optimizing for dollars per video frame trained. Everything at Tesla is about optimizing for something per dollar. Another great example of true innovation is Crispr. The gene editing technology is so powerful because it lowers the cost of iteration in biosciences. Now take companies like Uber, Lyft, Doordash, Peloton, Beyond Meat, Rivian, Lucid, FTX, etc. What are they optimizing for? Is there a conversation about cost? Are they iterating to bring down a ratio where dollars are involved? Most likely not. Those are good short candidates.
Conclusion
Shorting and buying innovation are two sides of the same coin. They speak each other's language. Innovation is about iterative engineering practices and the obsession to lower cost and increase customer value. Companies that apply those rules are true innovators and don’t make good shorts. The risk is too high. Amazon and Tesla are two examples. Companies that don't apply those basic processes in their business but claim to be innovators are good short candidates. The financial markets are littered with founders acting as imposters or even con artists, pretending to be innovators. To find them, short sellers must do the same work as long investors. Define true innovation and isolate those companies that don’t follow the process but claim to be innovators. There is plenty of room for such short sellers, and the financial markets would be well served with a large professional fleet of true short sellers. Unfortunately, a cottage industry of pretend shorts has emerged. These merchants of doom typically have little or no skin in the game. They claim to be short innovation and use splashy prose and convoluted narratives to spread doubt and negativity. They optimize for virality, not investment returns. Regardless of whether you’re long or short, having skin in the game is a fundamental requirement for any investor. Short sellers with no skin in the game are just financial market harlequins spreading doubt.