Shorting Strategy and Value Investing

How does shorting work?

Shorting strategy has been very popular since the bubble
burst of technology stocks in 2000. Shorting a stock is
simply a bet that the stock price will drop.

An investor can sell a stock he/she does not own by
borrowing shares from brokers. The investor can sell the
stock first and then buy back the shares at later time. The
investor can make profit if the stock price he/she sells is
higher than the price he or she buy back later on.

Shorting Strategy for Value Investors? At appearance,
shorting strategy should work well with most value
investors. The core task of a value investing is to
calculate the intrinsic value or the worth of a stock in
order to identify bargain stocks that are trading at
discount to their intrinsic values.

If a successful value
investor can buy cheap stocks based on their intrinsic
value, why not just short a over-priced stock?

In the end,
method for calculation of intrinsic value is same whether
the stock is overpriced or underpriced.

However, if you read carefully the value investing books
from Benjamin Graham, the father of value investing, you can
find very little information on shorting.

We also know that
Warren Buffet himself does not utilize shorting method. So
why is shorting strategy not used by 2 greatest value
investors in history?

Shorting Requires Higher Degree of DiversificationMutual funds are known to have extremely diversified
portfolio of hundreds to thousands of stocks.

Many successful value investors invest into concentrated
stock portfolio with adequate diversification. In the book
Intelligent Investor Chapter 5 titled "the Defensive
Investor and Common Stocks", Benjamin Graham preached
"adequate diversification" of 10 to 30 stocks, but not
"excessive diversification".

Warren Buffet was also known
to invest into portfolio of less than 20 - 30 stocks for his
hedge fund in earlier years and for his firm Berkshire
Hathaway.

Charles T. Munger, the second man of Berkshire
Hathaway, and a great billionaire value investor himself,
was also known to make even more concentrated bet than
Warren Buffet when he was alone managing his own hedge fund
before he joined Berkshire Hathaway.

My past investment
performance in Blast Investor Real-time Plus newsletter was
also obtained with concentrated portfolio of around 10
stocks as well.

However, this kind of concentrated portfolio common in value
investing world would not have adequate diversification with
shorting strategy. To illustrate this point, I put following
2 hypothetical cases for comparing a typical long-only value
investing portfolio and a short-and-long combined portfolio.

Case 1 - Long Only Value Investing PortfolioTable 1- Portfolio 1, Long Only PortfolioStock Long or Short $ USD for stock position1 long $10,0002 long $10,0003 long $10,0004 long $10,0005 long $10,0006 long $10,0007 long $10,0008 long $10,000A long $10,000B long $10,000Total Equity $100,000Table 1 is fully invested hypothetical portfolio with 10
stocks. All the 10 stocks are long position of bargain value
stocks.

Suppose for the 2 years, 1 to 8 stock price stayed
flat with no gain and no loss, and stock A and B each lost
90% of their value in the first year, and then not only
regained all the losses in the second year and actually
doubled from the original entry price.

Table 2 is
performance of portfolio 1 for this 2 years:

Table 2 - Performance of Portfolio 1Stock Initial Year1 Year2A $ 10,000 $1,000 $ 20,000B $ 10,000 $1,000 $ 20,000Portfolio1 $100,000 $82,000 $120,000Portfolio1 Performance NA -18% 46,34%90% of loss in 2 of 10 stocks in portfolio did not kill the
2 year overall performance of portfolio 1.

In fact,
Portfolio 1 still enjoyed overall 20% gain over the 2 years.

Case 2 - Long and Short PortfolioTable 3- Portfolio 2:

Long 8 Stocks, Short 2 StocksStock Long or Short $ USD for stock position1 long $ 10,0002 long $ 10,0003 long $ 10,0004 long $ 10,0005 long $ 10,0006 long $ 10,0007 long $ 10,0008 long $ 10,000X short $ 10,000Y short $ 10,000Total Equity $100,000Table 3 is fully invested hypothetical portfolio with 10
stocks. All 8 stocks (stock 1 to stock 8) are same long
position of bargain value stocks, and Stock X and Stock Y
are short positions.

Suppose for the 2 years, 1 to 8 stock
price stayed flat with no gain and no loss, and stock price
X and Y each increased 10 times in the first year, and then
not only lost all the gains in the second year and actually
further crashed and cut in half from the original entry
price.

Table 4 is performance of portfolio 2 for this 2
years:

Table 4 - Performance of Portfolio 2Stock Initial Equity Year 1 Equity Year 2 EquityX short position $ 10,000 -$90,000 $ 15,000Y short position $ 10,000 -$90,000 $ 15,000Portfolio2 $100,000 $ 0 (wipe out) $ 0 (wipe out)Portfolio2 Performance NA -100% -100%Although the investor correctly predicted that stock price
of X and Y would drop in 2 years, the first year rise of 10
times in stock price of X and Y triggered margin call in
portfolio 2. The 2 short positions of X and Y wiped out the
whole portfolio 2 so that the portfolio never had a chance
to profit in the second year of dramatic crash of X and Y
stock price.

Market Timing and Money ManagementAlthough the above -90% loss and 10 times rise hypothetical
cases are not common, this kind of wild ride in stock
market did happen. A stock price change from $1 to $10 or
from $10 to $1 was even less rare in small cap or micro cap
market.

A prudent investor certainly can not rule out such
possibility in portfolio management. Long term oriented
value investing with 10 stocks can certainly withstand this
kind of losses in case 1. However, the same kind of change
would not have chance of surviving for shorting strategy as
shown in case 2.

To avoid wipe out with short strategy, investor has 2
choices:

Investor either has to have a more diversified portfolio,
possibly with hundreds or thousands of stocks just like a
typical diversified mutual fund portfolio.or Investor would engage in short term trading or market
timing so that the investor can short at or near top to
avoid wipe out risk.

Neither of above 2 choices are attractive for a truly
successful value investor. First of all, concentrated bet
without excessive diversification is one of key reasons for
high performance.

With hundreds or thousands of stocks
under management, a portfolio with short strategy would be
as mundane as a typical mutual fund portfolio in terms of
performance. Second of all, value investing method is price
oriented long term investing method, which by itself is at
odds with any market timing or short term trading strategy.

Certainly, there are successful investors utilizing short
strategy in stock market. However, here is my final 5 cents
as below:

Great value investors such as Warren Buffet and Ben Graham
do not short, you don't need to either.* Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut.

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Henry Lu