Putting the Methods of Short Sellers to Work
By Chris Mailander
Boards can use the “walk back” method popularized by short sellers to benefit their companies and their own decision-making.
In the early months of 2023, a short seller used Twitter to shine light on Silicon Valley Bank’s (SVB’s) weaknesses. By March, the bank had collapsed. William C. Martin, the short seller, took his profits as the weak was sorted from the herd.
The recipe used by short sellers like Martin is relatively straightforward. Find companies with a material weakness. Determine if a bet against the company will have a big enough reward. Look for the potential trigger points that will tip the target into free fall. Go to social media to provoke it.
The trigger point for a company’s demise, such as Martin publicly highlighting SVB’s flawed balance sheet, however, is typically not the root cause for why it fails. It is simply the catalyst.
The cause for why a weakened institution is likely to fail is not some event that will occur in the coming days, weeks or months. Instead, the true cause roots back to decisions made or not made by the company’s directors and management years before. Most short sellers are targeting flawed judgment.
Over three decades of working with companies, national governments and politicians, I have studied the alchemy for how people exercise judgment. Some do so brilliantly. Many more do not.
Many companies fear short sellers, and rightly so. They are sharks hunting in the darkened waters of the financial markets, waiting for their time to strike. They taunt management. They tell others where to look for signs of weakness. To fan the flames, they identify by name the key directors on the board.
Instead of fearing the short sellers, directors should embrace their techniques. They should use their analytical methods as a means for bolstering their own decision-making. They should do so when the waters are calm, when they are on a string of success and long before they face the inevitable challenges presented by changed market conditions – interest rates move, the economy lurches, a competitor launches a gambit, or a regulator, the media or a short seller takes aim.
To begin, do the “walk back.” Make a list of potential trigger points that could create considerable adversity for your company several years out. Then, deconstruct each to understand what conditions must be true for that trigger point to manifest. Plot the company’s ability to withstand the challenge. By doing so, the directors are at the tip of the spear championing long-term value creation for shareholders.
Consider the two-decade run of one of the most successful ventures on Wall Street: AIG Financial Products. In the 1990s, AIG FP, as it was known, was one of the most creative hedge funds, consistently chalking up outsized margins through its ability to architect unique, creative solutions to financial conundrums too difficult for others to solve. AIG FP made lots of money solving the problems others could not.
In the early 2000s, AIG FP shifted its strategy under the leadership of its CEO, Joseph Cassano. As a result, it rode the wave of phenomenal growth in the U.S. housing finance sector by writing credit protections on a tiny sliver of exposure in this market. It was phenomenally profitable.
Long-running success like this, however, can often do something quite perverse. It can impair judgment. It skews decision-making. It sets a narrative within the organization that grows intransigent, establishing a common wisdom deemed right and scuttling dissent that sees things another way. It creates blind spots. Boards grow complacent. Vulnerabilities emerge.
Then, when there is a shift in the situational context for decision-making, these vulnerabilities can become open wounds. If ignored, they can fester. If untreated, they can kill.
The “walk back” method exposes where judgment is being skewed and how. It does so well in advance of a crisis. Consider how the method could have changed the trajectory of AIG FP, which today is now known in the relics of history simply for its decision-making failures as a precursor to the 2008 financial crisis.
Three years before the crisis, there were early indicators that the quality of housing finance securities was degrading markedly. The situational context was shifting. Some players in the market, like Goldman Sachs, saw the negative trends. They set to work quietly moving risky assets off their balance sheets. They bought hedges. They began orchestrating a path that would brace them for a market that would inevitably grow choppy in the months ahead.
AIG FP did none of these things. The CEO was slow-footed. The management at the parent company was in the dark. The directors were on the sideline. The board would later be thrown into the very center of the crisis charged with saving shareholder value at one of the most successful global companies ever built. It was too late.
SVB’s demise has certain parallels. Over a 30-year history, SVB grew slowly, year-over-year. Something changed in its last five years, beginning in 2018. The bank quadrupled in size, growing from $50 billion in assets to over $220 billion. It became the sixteenth largest bank in the country. SVB’s CEO, like that of
AIG FP, had seemingly built a beautiful machine. The board, quarter over quarter, applauded the success.
Something deeper, however, was amiss. It traced back to decisions made several years before. Martin, the short seller, was pointing to it on Twitter. SVB had bet against the likelihood — perhaps even the probability — that the Fed would begin raising rates to temper an overheating economy. SVB’s bet was not a little bit wrong; it was very wrong. Over the past year, the Fed has raised rates to their highest level since 2006. For companies led by the savviest boards, the “walk back” method can do something else. It can be the source of the company’s greatest competitive advantage.
To begin creating this advantage, think like a short seller. Deconstruct a competitor’s decision-making process. Determine the intractable variables that drive their decisions, such as SVB’s intent focus on achieving hypergrowth equivalent to the bank’s technology company brethren in Silicon Valley instead of carefully stewarding its balance sheet. Look for blind spots, including what it is that the management teams can or cannot see.
Look for CEOs imprinted with decision archetypes that work well in one context but will perform poorly in alternative situational contexts. Cassano, for example, was immensely successful at harvesting a small slice of fees from a massive financial machine, but unable to perceive his exposure to liquidity risk if the situational context shifted. SVB focused on a continued string of quarterly earnings, but failed to manage mismatched liabilities on its balance sheet if interest rates went up. SVB’s management team mistakenly allowed themselves to be painted into a corner from which there was no exit.
It is the obligation of boards to reveal these blind spots and preempt managers successful in one domain but ill-suited to manage the company’s unique challenges under new conditions.
Short sellers are constantly at work. They hunt in agitated markets. The agitation reveals companies that are vulnerable, often because of decisions made or not made by boards and management teams when the waters were calm long before.
Despite the lore, most short sellers do not cause companies to fail. Martin didn’t cause SVB to fail. Michael Burry, the short seller in The Big Short, didn’t cause the 2008 financial crisis, nor did he cause AIG FP to fail. Instead, they positioned themselves to profit when their targets failed.
Most companies fail because of flawed decision-making by boards and management teams long before their crucible moments. The analytical techniques of the short seller can be reverse engineered by elite boards to get the decision right for when it will matter the most.
Chris Mailander is director of and strategic advisor for Miles Ahead Brands/NewMile, advisory board member of Medici, CEO of Ironheart Corporate Advisory, managing director of Vu Partners LLC and author of Judgment: The Art of Momentous Decision-Making.