Whenever I meet fellow value investors, our conversation inevitably turns to investing style. Some prefer credit, others equity. Some U.S., others international. Some focus on a near-term catalyst while others are content with an attractive valuation. The conversation usually turns to shorting at one point: “Do you short?”
The answers vary: 1) “No, my fund doesn’t have the mandate.” 2) “No, I buy cheap assets. Shorting is challenging.” 3) “Yea, we short. It’s a tough game but we think we can add value.” When the response is the latter, the answer tends to be a touch sheepish. Why?
Why do value investors stigmatize short selling? Is value investing not simply arguing that the market’s valuation of a company is incorrect for various reasons? Why should investors focus only on long investments?
Ben Graham, widely regarded as the father of value investing, shorted overvalued firms, as well as engaged in what we now call event-driven investing (including spinoffs, merger arbitrage, securities conversions, etc.). So if the father of our methodology sold securities short, why do many avoid shorting in their pursuit of market-beating investment performance?
Here are my top 10 reasons value investors avoid shorting:
1. Legal restrictions: A large majority of assets are managed in “plain vanilla” mutual funds which do not permit managers to short securities.
2. Warren Buffett doesn’t short: While superficial, do not underestimate this one. Many value investors liberally quote Buffett and consider his opinions to be fact. (Author’s note: In fact, this topic will make a good blog post during the next week, so stay tuned.)
3. Misaligned incentives: Company management, Wall Street investment bankers and long-only investors all make more money when security prices rise and thus have solid incentives tomanipulate “encourage” higher share prices by focusing on a company’s positive attributes.
4. Markets tend to increase over time: The S&P 500 has returned approximately 9% annually for 100 years. A short valuation call has to be accurate both with respect to valuation and timing.
5. “Markets can remain irrational longer than you can remain solvent”: This iconic John Maynard Keyes quotation definitely applies to shorting. Many investors have been taken to the woodshed shorting companies that were trading on clicks, projected growth or other non-traditional metrics (such as free cash flow).
6. Borrowing shares can be expensive: To borrow shares a short-seller must pay any dividends issued by the company, as well as interest to their broker. For popular shorts, interest rates can be usury (40% to 60% or more per year). Again, this forces a short-seller to be correct within a certain time frame, for the position to pay off.
7. Shorting = “Trading”: To some value investors, “trading” is the intellectual equivalent of two-buck chuck to a wine enthusiast. Most short-sellers have a limited time frame due to the aforementioned cost of shorting which necessitates more frequent portfolio changes.
8. Shorts can only make 100%: A solid long investment can make way more than 100%. The effort spent finding and researching an investment that can make over 100% is more efficient than one in which the company literally has to file for bankruptcy for a short-seller to make 100%.
9. Short position size increases with price: When a long investment declines in price, the position becomes an ever-decreasing part of the portfolio. As painful as this can be, the math automatically minimizes the position loss. When a short increases in price, the position grows as a percentage of a portfolio – adding insult to injury!
10. Shares can be “called in” at an inopportune time: In September 2008, the SEC expressed disallowed shorting of nearly 800 financial firms. The U.S. forced hundreds of funds and individuals to close their short positions right before financial firm share prices tanked. This is the United States! Not a third-world country! While an extreme example, even in a normal environment shares can be called in by a broker for various reasons – forcing the short-seller to close the position against his will.