valuebeacon

My Short Basket

In Short selling, Technology on May 28, 2014 at 10:17 am

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Tech Bubble Redux

Shares of many Internet technology companies are trading at prices that far overstate their economic worth. There is both qualitative and quantitative support for this. On the qualitative side, here are a few points:

  • The IPO market of late has been very receptive to companies with limited operating histories and unproven profitability.
  • There has been a resurgence in the use of non-conventional valuation metrics (“per user”) to justify valuations by investment bankers, venture capitalists and companies doing M&A.
  • Mergers and acquisitions activity; within the technology industry, acquisitions are taking place at absurd prices. Some examples include Facebook’s $19B acquisition of WhatsApp, a company with significantly less than $1B in revenue and no earnings.
  • Startups are flush with cash based on high valuations in fundraising rounds. See this job posting from Rap Genius.
  • News stories commenting on high valuations of tech companies.
  • Some hedge fund managers taking short bets. See Greenlight Capital’s recent letter

Short basket

I’m not a big fan of short selling. It’s risky. And the upside is limited. But it is one tool in the investor’s toolbox to be used when necessary.

In order to take advantage of high valuations, I am selling short shares in a handful of technology companies. Rather than shorting an index or a few specific companies, my approach is to put together my own basket or index. There are fourteen companies in my basket. I looked for companies with high multiples of enterprise value to revenue and little to no earnings or free cash flow. These are the ones I found: Netflix, Facebook, Salesforce, Twitter, Zynga, Tesla Motors, LinkedIn, Amazon, Pandora, Zillow, Zulilly, Splunk, Workday and Fireeye

Metrics

In terms of metrics, were you to invest an equal amount in each of these companies, here are the ratios you would end up with in your basket:

  • EV/Sales multiple of 7.52x
  • Earnings yield (0.84)% – Yes, that’s a negative earnings yield
  • Free cash flow (aka owner income) yield 0.41%

Given these metrics, it would take significant improvement in earnings and free cash flow to make these companies a good value. But shorting is not without risk. These companies are fast growers and likely many will eventually growth into their valuations. This is by far the biggest risk. Add to that the risk that overvalued companies can easily become more overvalued.

To see how this short basket is performing, login to Yahoo Finance using username ‘valuebeacon’ and password ‘Warren$902’. Click on My Portfolio -> Performance.

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