This is somewhat of a tricky subject for Value investors. Warren Buffett (WB) doesn't short - for very good reasons. Most of the seasoned value investors that we emulate are long only portfolio managers. Berkshire Hathaway shareholder letters are said to be everything one needs to know in order to make money in the markets but WB lists no rules for shorting. Ben Graham on the other hand pair traded, but WB dint copy that practise because he observed that for every 4-5 'wins' there was a 'loss' which would more or less wipe out the 'wins'. On the other hand, there are many enterprising investors Paulson, Watsa et. all that successfully shorted in the past 2 years and made a killing. Anyone who was long only in the last 2 years has lost money. Anybody who was short anything has made money. This means that the outcome was favorable, but was the decision right? If the decision was right the process must have been right. On the other hand, if the decision was wrong, then 'luck' must have all the credit and not the process. Lets look at this.
Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!
One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.
In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.
Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.
In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.
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3 comments:
I'll agree with you that shorting is within the value investing framework, but I think 99% of the time, shorting is by far the riskiest thing one can do simply because the market prices can and often do remain irrational far longer than the investor can remain solvent.
Everything I have read about value investing can be applied to any asset class or investment strategy (long, short, arbitrage). Buying overpriced shares in a blue chip can be riskier than purchasing the beat-up shares of a small cap. It's all about risk and return.
A proxy I use to identify companies returning value to shareholders is dividends and share repurchases, which in my mind are equivalent. On the short side, companies can't give negative dividends, but they can consistently increase their outstanding share count. It's effectively a negative dividend. If they're using that money to invest in projects that earn a higher rate of return than shares, EPS should rise. If not, EPS should fall, and if this is an integral part of a companies strategy, they are destroying value. This is even more true for companies that consistently report a loss, but you should see decreasing loss per share as shares are diluted.
For me, value-destroying shorts feel much safer than companies that are just "overvalued". A company trading at a high earnings or cash flow multiple can grow into its high valuation. Likewise, a company destroying value isn't an attractive buy even at extremely low prices. To be logically consistent, a short should be the mirror image of a long.
As far as options are concerned, I completely agree that puts offer a much better risk/return trade off than a naked short. I think that for true margin-of-safety investors, options offer an analyst to identify two sources of inefficiency... valuation and volatility. For a put to be attractive, the underlying should be overvalued and/or the implied volatility of the put should be low. If that's the case, investors can be wrong on one and still have a profitable trade. Plus, by choosing an expiration date, the investors says "I expect something to happen before this date". It's hard to get stuck holding a position you really should be in when the active decision becomes "should I roll these over when they expire" rather than "should I sell something I really don't like anymore even though it hasn't been profitable yet". You force yourself to avoid a well documented bias to hold loosers.
WB did short back in the days of his partnership. In the latest biography he was short 7M on around 37M in AUM
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