• Introduction to LQS: A Safety Mechanism to Help Protect Short Sellers of Low Quality Firms
  • Low Quality Signal (LQS) Characteristics and Persistence
  • LQS Impact of Performance on: Trading Shorts, R1000 Shorts and Small & Mid Cap Short Model
  • Conclusions

Introduction to LQS: A Safety Mechanism to Help Protect Short Sellers of Low Quality Firms

In 2010 Kailash Capital began a bespoke research project for a Tiger Cub on a high speed “Trading Short” model that sought to exploit shorter holding horizons. The Trading Short Model targets low quality firms by integrating three separate models:

  1. A model that seeks out firms consuming cash with poor momentum scores
  2. A model that seeks out firms with high street expectations, poor capital allocation policies and a recent tendency to disappoint street expectations and
  3. A model that looks for firms that are among our lowest ranked stocks in our core models that also possess price and volume metrics that point to impending fallout

Built around Kailash’s inception in 2010 the backtested results proved compelling enough to become a product. Examining the original research Kailash observed that the Trading Model’s results tended to experience multi-month stretches of outperformance and underperformance. Kailash set out to build a signal that might help improve the model’s results by flagging when the picks are about to go on a “hot” or “cold” streak. This flag, dubbed the Low Quality Signal (LQS) would go “Active” when the shorts should be pressed and “Inactive” when the shorts should be moderated.1 The LQS signal generated substantial improvement in the Trading Model’s backtested performance. Kailash has been distributing both the Trading Shorts and the LQS since their design in 2010. Since launch we have watched with growing conviction as this timing flag has proved to be a powerful risk mitigation and performance enhancing tool not just for the Trading Shorts we publish but across all the short models we publish. A decade of real-time performance is a non-trivial period for a signal to prove its mettle.

The short seller’s Low Quality Signal (LQS) attempts to discern when securities whose valuations Kailash believes to be more speculative in nature are likely to experience atypically strong performance. Kailash’s predisposition to shop for short candidates among firms we believe suffer from aggressive accounting, suboptimal capital allocation, valuations predicated on narratives rather than cash flows or some combination thereof means our shorts will typically be susceptible to painful price appreciation when low quality stocks get a boost. The signal is consistent in its data sources, was built near firm inception in 2010, does not allow any manual intervention by Kailash and is purely quantitative in construction. This short seller’s Low Quality Signal (LQS) is actually not something we have used in our asset management practice simply due its conceptual proximity to market timing.

This has proven to be an unfortunate decision as the signal’s backtested results (pre 2010) have only improved in the real world. In Kailash’s paper Activism Lite: A Case for Meeting Management Part II our firm took a concept from academia suggesting the momentum anomaly seemed to accrue disproportionately to lower quality firms. Since the Trading Short Model targets companies of this type it seems intellectually consistent that these firms would be the most sensitive to capital flows. In a world characterized by QE ad infinitum that has created an incomprehensible pool of $14 trillion in bonds that guarantee losses we believe these fund flows may be a global phenomenon that has an outsized impact on low quality speculative firms’ performance.

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Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

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