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 Diversification Mutual 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 Portfolio Table 1- Portfolio 1, Long Only Portfolio Stock Long or Short $ USD for stock position 1 long $10,000 2 long $10,000 3 long $10,000 4 long $10,000 5 long $10,000 6 long $10,000 7 long $10,000 8 long $10,000 A long $10,000 B long $10,000 Total Equity $100,000 Table 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 1 Stock Initial Year1 Year2 A $ 10,000 $1,000 $ 20,000 B $ 10,000 $1,000 $ 20,000 Portfolio1 $100,000 $82,000 $120,000 Portfolio1 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 Portfolio Table 3- Portfolio 2: Long 8 Stocks, Short 2 Stocks Stock Long or Short $ USD for stock position 1 long $ 10,000 2 long $ 10,000 3 long $ 10,000 4 long $ 10,000 5 long $ 10,000 6 long $ 10,000 7 long $ 10,000 8 long $ 10,000 X short $ 10,000 Y short $ 10,000 Total Equity $100,000 Table 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 2 Stock Initial Equity Year 1 Equity Year 2 Equity X short position $ 10,000 -$90,000 $ 15,000 Y short position $ 10,000 -$90,000 $ 15,000 Portfolio2 $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 Management Although 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. |
