In the 1994 action movie Speed, the plot follows the travails of LA cop Jack Traven as he tries to save the passengers aboard a bus travelling through Los Angeles which is rigged to explode if the speed drops below 50mph. It’s a classic action-packed 90’s flick (and apologies if you’d been anxiously waiting 30 years to watch it), but ultimately Jack is successful and disaster is averted.
The shareholders aboard the Transaction Capital mini-bus were unfortunately not as lucky, and the March trading statement revealed that bus has indeed slowed down quite far below 50mph, with the resulting share price detonation equally reminiscent of a 90’s action blockbuster.
There were a number of signs of deterioration evident in Transaction Capital’s 2022 financial statements that indicated to attentive investors that there might be trouble ahead.
As fundamental short sellers, anticipating and positioning for earnings disappointments is how we aim to generate alpha on the short side and Transaction Capital was the second largest short position in our hedge funds in early March (and avoided in our long only funds).
Readers of previous pieces will recall that our typical shorts come in several different flavours. While frauds make the most interesting stories, they are also less common. The vast majority of companies we short (like Transaction Capital) are businesses which are simply experiencing fundamental weakness which is not well-understood by the market. Timing is also important in shorting. Practically, this means both identifying the busses that have been rigged to blow, and also timing our short for when we think there’s traffic ahead.
Most of these are what we call Earnings Quality shorts, where the reported earnings show signs of fundamental weakness or stress and we expect this to manifest in future disappointment, with earnings as the catalyst. IFRS Reporting Standards allow significant flexibility in accounting judgements and estimates – so R1.00 of Reported Earnings Per Share (“EPS”) could in reality mean an Economic EPS of anywhere between R1.50 and R0.50, depending on the specific accounting policies applied. As company fundamentals begin to deteriorate, this is not always immediately apparent, but there are often clues in the accounting. Ultimately, as the bus’s speed continues to drop it tends to eventually emerge, and sometimes as a nasty surprise.
There were a number of signs of deterioration evident in Transaction Capital’s 2022 financial statements that indicated to attentive investors that there might be trouble ahead. Among these were one-time gains in earnings, a lower accounts receivables provision despite a bigger receivables balance and deteriorating ageing, swelling stocks of repossessed taxis within SA Taxi (to almost the size of WeBuyCars stock on hand) and lengthening loan terms. Furthermore, earnings were temporarily inflated as a result of supra-normal used car margins, which our research suggested was on the way down. Additionally, the market multiple of 23.5x reported earnings (or 30x our economic earnings) reflected a very optimistic outlook. Ultimately, as the deterioration worsened and triggered their March trading statement, the economic reality and the market’s perception thereof converged suddenly, leading to a significant share price decline of almost 70% peak to trough.
Transaction Capital is one recent example, but over 14 years our short book of 25 to 30 individual stocks has generated annualized alpha of 16% per year, primarily by identifying and positioning shorts around likely earnings disappointments, which are not readily apparent from the headline reported numbers. For fundamental short sellers, this skill is equally useful on the long side and can be inverted to identify companies where reported numbers are understating fundamental economic strength (the topic of a future piece), and of course also by avoiding short candidates on the long side.
In the current difficult economic environment, the dispersion between solid company fundamentals and weak ones is likely to continue to widen. This presents an attractive environment for fundamental hedge funds that can identify and take advantage both of those companies likely to outperform expectations and those losing speed.