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Wednesday, June 10, 2009

"301K" and Momentum Shorting - The Trend is Your Friend Until it Isn't

The market volatility of the last year was both mind numbing and full of opportunity for long/short investors. Of course, the timing and extent of the massive downswing and subsequent market recovery were impossible to predict. While the sustainability of the recent market recovery remains a question, it's worth noting that the "201K" so lamented in mainstream media is now almost back to a "301K" (S&P500 down only 31% from the index's 52 week high of 1367 versus down 51% at the low). Things can change quickly. At some point, we believe the "301K" will once again be a "401K".

For long-term oriented investors, market volatility creates opportunities to establish positions in quality businesses at substantial discounts to cash flow based fair values. Likewise, many short-term oriented market participants -- traders -- strive to capitalize on both changes and trends in market sentiment and fundamentals. Last fall, downside bets based on negative sentiment and rapidly declining fundamentals became "the trade that worked" and momentum shorting was en vogue. While there are many examples, we'll focus on one: Tyco Electronics (TEL, $19.90, link to price and other information here).

Tyco Electronics is an established market leader in the electronics components space, with competitive advantages such as brand and longstanding customer relationships, as well as scale and leading market share (perhaps two times that of the company's nearest competitor, Molex, MOLX, $16.53). However, Tyco Electronics faces a large near-term obstacle that made/make the stock a popular short target: approximately one third of revenue is automotive related. As economic data worsened and many facets of the economy essentially stopped in November/December, TEL shares declined from the $30s to the mid-teens, ultimately bottoming at $7.40 in early March.

During this time, the shorts piled into TEL, with the total short interest reaching 12.8 million shares in mid-March (after the bottom), up from only 2.8 in mid-September. Indeed, fundamentals were bad with no improvement in sight. The short interest continued to increase to 13.6 million shares at 4/15/09 before guarded market optimism and upward movement forced some shorts to cover their positions at higher prices despite poor fundamentals. We note that short interest as a percentage of total TEL shares outstanding remained relatively low at 2-3% compared to certain small/mid-cap companies where short interest can reach >20-30% of float and fuel tremendous short covering rallies -- see Blue Nile (NILE, $46.79) and VistaPrint (VPRT, $44.26 - favorable fundamentals also helping VPRT).

On April 29th, Tyco Electronics reported quarterly sales down 33% Y/Y to $2.5 billion and total company orders down 42% Y/Y (down 38% on organic basis) with a book to bill ratio of 0.90x (link to results here). The results seemingly validate the simple short thesis (prima facie: things are horrible, short it!), yet shares of Tyco Electronics are now currently trading close to $20, which in our view, illustrates the difficulty of predicting short-term market/stock moves. Ultimately, share prices are driven by fundamentals, so if real economic improvement doesn't materialize later this year (consensus view), we suspect TEL's upward trajectory could reverse course in the near-term (which is consistent with 5/29/09 uptick in short interest).

To conclude: we believe momentum shorting played a large role in pushing the market to extreme downside levels over the past year, with subsequent short covering driving rapid 2x, 3x, and even 4x recoveries over the past several months for companies with still uncertain outlooks. Momentum shorting is not our style, but plenty of traders believe the trend can be your friend on both the upside and the downside. This can "work" for a period of time. The only problem is that you never know when your friend might change directions and leave you holding the bag.

Happy investing,

Jeffrey Walkenhorst

Disclosure: none.

© 2009 Jeffrey Walkenhorst
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