Ask any fund manager: Shorting is hard. Many elements make it hard to generate a positive return on shorts. After all, in the long run most stocks go up. Even worse, when your shorts move against you, they become larger as a percent of NAV, not smaller – compounding the pain of your mistakes. So why do it? And how do we at Crossroads avoid the common pitfalls? Below is a quick primer on our approach, and an example that fits our criteria.
Our shorting framework
First is the why? At Crossroads, we are dedicated to identifying undervalued businesses and strategically positioning our hard-earned capital to maximize returns as the market recognizes their true worth. This cuts both ways, long and short. The question we ask ourselves is “If we can discover great businesses trading at prices that make no rational sense, why can we then not find the opposite?” More to the point, if we can do it successfully and manage our risk well, we are in a much better position to deliver outsized absolute equity returns while minimizing our market risk, certainly vs. traditional long-only equity strategies.
Granted, it’s true that the risk of a short position is theoretically unlimited, and your upside is ultimately capped at 100%. Yet there is more to this long/short story than investors touting that warning typically suggest. In fact, the practical reality is there are a lot more terrible companies than good ones in public markets. Better yet, we think legendary short seller Jim Chanos said it best when he wryly noted, “I’ve seen a lot more companies go to zero than infinity.” For a less tongue in cheek data point, consider that 40% of equities in the Russell 3k exhibit negative absolute returns over their lifetime, with 66% underperforming the index itself. [1]
Another key fact to consider here is that much of our time at Crossroads is devoted to assessing whether a company is a worthy undiscovered compounder or catalyst-driven “special situation” (or both) for long-term investment. Yet, the truth is for every exceptional business priced to reflect the opposite that we uncover and ultimately invest in, there are dozens of subpar ones we discard — the jetsam of our risk-averse investment process, an unavoidable aftereffect of embracing Peter Lynch’s philosophy that 'He who turns over the most rocks wins.' From our perspective then, better to use it to our collective advantage, especially considering we've already sifted through these opportunities to begin with. Why not flip the script and invert our research focus, leveraging the crème de le crème of the worst ideas we’ve come across when we have a pretty good idea of what will make that particular short candidate work – and more specifically, when? After all, time spent on research is invaluable, and the cost of missed opportunities is high. So, by shorting, we leverage our research process to full effect and maximize our opportunity set to profit from Mr. Market’s manic mood, which in turn puts us in a better position to protect our portfolio of carefully selected longs during downturns. Shorts also provide a critical source of funds in difficult times, allowing us to average down on our highest convictions longs at a time when the implied risk-adjusted forward returns are typically the best.
In any case, a beneficial byproduct of flexible thinking in this manner is that it allows us to sharpen our understanding of a business or sector and not get unmoored from determining truth, whichever way it cuts. And indeed, over time we’ve found that our track record in shorting is better than 50/50 and a net contributor to our returns against a backdrop that, let’s face it, has been anything but kind to the average short seller.
Below, we take a few minutes to briefly describe what our process looks like. Experience has taught us that perhaps the best way to begin articulating our investment framework on short selling is to emphasize what we don’t do. Here are three common short selling tactics we tend to avoid as a general rule:
1. We don’t short frauds, although we do short “zeroes.” Lincoln may have been right when he said you can’t fool all the people all the time, but frauds can fool a lot of the people for a lot longer than you might think. We prefer situations where the negatively reinforcing dynamics are so strong that any financial chicanery or other attempts to arrest the “doom loop” only delays the inevitable.
2. We avoid crowded shorts. Risks compound from the action of other short sellers, and the cost of carry can be exorbitant when fishing in crowded ponds. However, if we see a crowded short with a highly probable event path over a defined timeframe, we may look to the options market. Every now and then, we see a name that’s on its last legs, but with the options market pricing in nothing of the sort. In a case like that, rather than shorting the common equity like everyone else, options often times give us a cheaper, less risky opportunity for profit without costing us our mental health in the process.
3. We don’t short based on valuation. This may sound paradoxical, but it’s in alignment with our overall investment philosophy: We look for mispriced opportunities based on insight into a particular business’s qualitative characteristics and future prospects - and what that tells us relative to the market expectations currently embedded in its equity. Valuation in a vacuum just tells us how large a potential share price correction could be if it surprises the market positively or negatively. After all, when something is trading for a price that’s 3x crazy there is no good reason to believe it can’t trade for 10x crazy, i.e., if you don’t have a crystal-clear idea of what will bring those lofty expectations crashing down to earth in the near-term. For shorts, a high valuation on normalized earnings, with our qualitative work pointing to disappointment close at hand, is always the cherry on top – but never the whole sundae.
So that’s what we don’t do. What do we do? We are looking for businesses undergoing value-destroying change (as opposed to long ideas undergoing value-unlocking change). This change usually comes in the form of new market entrants, structural disadvantages from emerging trends, and an unwillingness or inability to address these threats. This approach lets us short at the outset, and, as the business continues to underperform, add to our position over time (sometimes called ‘laddering’, hence the title of this piece, and no, we don’t mean “short ladder attacks”) Path dependency is critical in shorting, and we believe this approach allows us to be flexible in the face of new developments without getting too offsides.
While some of our shorts have exhibited varying degrees of the characteristics above, our best shorts (or the ones that get us excited) exhibit all these. While we’re understandably quiet on most of our short book, below we take a look at one name that exemplifies our process: ZipRecruiter.
ZipRecruiter: Everything we like in a short, plus an implicit macro hedge
ZipRecruiter (ZIP) claims to be a two-sided marketplace for job seekers and employers that uses a proprietary AI to curate and improve the recruiting process. In actuality, the company is more akin to an employer-paid job advertising channel charging SMBs on a per-job-posting basis that utilizes an inferior business model that requires massive spending in sales and marketing to maintain market share. Structurally, ZIP’s revenue is the first expense cut at an employer when hiring needs fade or a downturn occurs. We could go on, but the disconnect between what ZIP claims to be and what it truly is, couldn’t be more pronounced (qualitatively speaking).
One way this can be gleamed, is by looking ZIP’s leading competitor Indeed, a business that is much better positioned to benefit from the structural trends ZIP claims to be exposed to: digital hiring and onboarding, not just job listings. In a clear sign of superiority, Indeed’s data is now used at the Fed as an input to its labor market analysis. Conversely, the area in which ZIP truly competes, job listings, is a largely commoditized “no moat” niche with dozens of other similarly undifferentiated job sites all fighting for share. Critically some of these sites provide the same service as ZIP but for zero cost to incentivize the use of other more profitable bolt-on services.
To add insult to injury, even a year after the emergence of LLMs (large language models), which offer a cheap way to implement AI solutions, ZipRecruiter still seems intent on spending over 20% of revenue on R&D (~$150M per annum) to refine “Phil,” its AI chatbot. Given that an AI’s improvements come from bigger datasets, Indeed’s larger scale relative to ZipRecruiter makes AI an unlikely basis for ZIP’s long-term differentiation, if not an outright waste of that money. Money that could otherwise be returned to shareholders rather than lit on fire chasing an impossible dream.
Other marks against ZIP include (1) its issuance of high-yield debt to fund a repurchase program seemingly designed to backstop insiders exiting than to create value for ordinary shareholders, and (2) a third-party investor relations team that had no active phone number and that failed to reply to our repeated emails.
At any rate, since the company generates earnings from what is essentially job listings, it’s a bet on the direction of job openings and labor scarcity. When we put on this short in 2023, unfilled open job listing (JOLTs) and labor turnover (quit rates) were ~2x the pre-pandemic norm, unemployment was close to a cyclical low at ~3.7%, and the Fed’s financial tightening was expected to impact the labor market last in a long series of secondary impacts. So here was a company on the cusp of getting hit with a double whammy of micro and macro trends, losing share to lower/zero-cost competitors and a reversion to the mean in job listings partly induced by the Fed.
On valuation, ZIP traded at an unassuming 10x+ adjusted EBITDA (which is mostly stock-based compensation), but this multiple reflected assumptions of unreasonably high margins just as its margins were likely to get destroyed. In short, it was much more expensive than the backward-looking headline valuation suggested. Pair that knowledge with an industry whose trough multiples of earnings in labor market downturns has averaged 5x for peers (historically speaking), and the absolute and relative downside from a one-two punch of multiple compression and decelerating fundamentals looked quite severe under most reasonable future scenarios.
Finally, the stock wasn’t on many people’s radars. Short interest was in the single digits, and cost of carry was nominal.
As such, a short thesis for ZipRecruiter hit all our marks. So how did it turn out?
Outcome and Opportunity
We shorted ZipRecruiter in June of 2023 and exited in August 2024. Over that period the share price declined ~50% from our average entry price to our average exit price. During that time, our thesis largely tracked as expected. That is not always the case, but a welcome situation none the less. While this is in line with what we like to see from our short winners, regulators would like us to remind you that this example is for illustrative purposes. There are certainly times when we are wrong and times when we are right but share price does not decline as much.
As for financial performance since taking our initial position, revenue went down ~45% since the end of 2022, with EBITDA dropping to single digits in dollar amount and margins. Sales and Marketing ran at ~45% of revenue and R&D spending amounted to 25%-30% of revenue. Driving the decline in earnings was a 35% drop in paid employers on the platform, mostly SMBs. This drop was in excess of a ~25% decrease in job openings (JOLTs) during that time period.
The company still seems quite intent on spending over $100M per annum on its AI chatbot “Phil,” but one wonders why they haven’t just bought a ChatGPT subscription and dumped in all their data for 50% of the price. This is half joking and half serious, a company sticking to ‘what has worked’ instead of the newest and most scalable solutions is typically a red flag. Meanwhile, Recruit Holdings (6098.JP), owner of Indeed, is up in both stock price and earnings, as it’s a true enabler of secular digital hiring trends.
Given its depressed earnings, ZIP trades at an elevated 18x adjusted EBITDA, with SBC running at ~80% of adjusted EBITDA and over 100% of CFO.
The consensus holds that ZIP is troughing on its KPIs – and in the near-term it might be right. However, JOLTs are still 20%-25% above pre-pandemic norms, while unemployment is at 4.1%. We may be quite far from a labor market induced economic downdraft. However, in the event of a recession, JOLTs could drop 40% to trough levels with unemployment spiking well above 5%. In that case, a 5x EBITDA valuation on further depressed earnings could result in a share price in the low single digits. So even after a poor couple of years for ZipRecruiter, there’s still plenty of downside given its weak industry position and exposure to labor market trends that have an event path skewed to the downside.
Conclusion
We hope this quick piece helps you understand why and how we short. It’s arguably trendy these days to say that value investing doesn’t work, or shorting doesn’t work. On that last point, recent reports show that short interest, the number of shares borrowed short, are at the lowest levels in decades. Yet we continue to find great opportunities and while they are few, we believe the ability to go short is another arrow in our quiver, helping us to be successful investors over the long-term whatever the future holds. Rest assured we continue to like our odds, at least that much we can say for sure.
On a final note, while this thought piece shows a successful example of short selling, it should be reiterated we’ve had plenty of shorts that were not winners. As always, feel free to reach out to discuss our full track record on shorting, ZipRecruiter, or other opportunities we’re seeing at Crossroads.
Sincerely,
Ryan O’Connor, Founder and Portfolio Manager
Daniel Prather, CFA, Director of Research
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