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Top 10 Reasons Value Investors Avoid Short Selling

December 18, 2012 | About:
Value investors are an irascible bunch. We ply our trade away from the hubbub of Wall Street’s fast money and bright lights. What gets us excited is finding salient nuggets of information few others recognize, and utilizing the information to capture market inefficiencies. Ah, the elusive “buying a dollar for 50 cents!”

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.

About the author:

GrizzlyRock Capital
Mr. Mowery is a long-form thinker and value investor with a credit focus. In 2011, Mr. Mowery founded GrizzlyRock Capital which is a long / short investor in corporate debt and equity. Prior to founding GrizzlyRock, Mr. Mowery held leveraged finance positions on both the buy-side and sell side. Mr. Mowery holds an MBA from the University of Chicago Booth School of Business and a BA in Economics from the University of California, Los Angeles. Mr. Mowery can be reached at kyle@grizzlyrockcapital.com.

Visit GrizzlyRock Capital's Website


Rating: 2.9/5 (14 votes)

Comments

swnyc2
Swnyc2 - 1 year ago
GRC,

How about one more?

Any profit from short selling is taxed at the higher short term capital gain rate?

batbeer2
Batbeer2 premium member - 1 year ago
Here's a short.

Since I wrote about it June of 2010 it went down 90%. (adjusting for reverse splits). I made some money buying the inverse in 2011. A friend of mine made A LOT of money shorting directly.

Then it went down another 30%.

In my view, it was (and is) a value investment. It's perfectly safe unless you run out of patience or overdose on leverage. I wouldn't do this today but it is worth tracking just in case the markets gets really scared. That's not the case today.

GrizzlyRock Capital
GrizzlyRock Capital - 1 year ago
Swnyc2,

Sure, that could be a minor factor to some high tax paying investors. For this to be a real reason for certain investors not to short they would need to take the same tack on the long side.

As you know, most investors worry first about investing gains then tax consequences. May you always have tax problems!

-Kyle
GrizzlyRock Capital
GrizzlyRock Capital - 1 year ago
Batbeer,

What you are talking about is capturing option theta (time decay). While it's a profitable trade the majority of the time, a levered short VIX trade can run hard against you in the short term. [size=12px][/size]If I were thinking about a short VXX trade (which I have never done) I would structure in one of two ways:

(1) Hold a small short position irregardless of market liquidity and let the math work for you.

(2) Wait for a spike in volatility and then put the position on in more size.

The counter-argument to this trade is that it will be highly correlated with market moves. A "typical" short would likely make money during a broad market sell-off. Many short sellers prefer to have less portfolio vol than this trade would represent.

-Kyle
batbeer2
Batbeer2 premium member - 1 year ago
>> If I were thinking about a short VXX trade (which I have never done) I would structure in one of two ways:

(1) Hold a small short position irregardless of market liquidity and let the math work for you.

(2) Wait for a spike in volatility and then put the position on in more size.


Yes.

As for Alphas Betas and thetas, I truly have no idea what they mean witing the context of investing. As far as I'm concerned, these are cars built by Lancia.

Since the buyers of VXX buy that stuff to protect themselves against shot-term volatility, I think of the (short) sale of VIX as an insurance operation. At the right price, it can be highly profitable and if you do not overreach (leverage) the odds are with you over time.

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