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The Long and Short of It

August 31, 2013 | About:
David Chulak

David Chulak

29 followers
The market is a wacky phenomenon that by all accounts acts independent of the way in which we perceive its supposed direction. In simple words, you can’t guess what it will do next. We cannot wish it into complying with our desires. The last several years have been extremely difficult for many investors, concerned about the overvaluation in stocks, macroeconomic issues, etc. What’s more perplexing is the noise from that entity known as Wall Street that cries that stocks are cheap and that all is well, while others sing the opposite story. Deep within, many of us have serious doubts and are waiting for something to happen, not knowing what that something may be. A pullback? A major downturn? A crash? Maybe it will keep going up and we will miss out while sitting on the sidelines.

Benjamin Graham warned us of this very fact. His story of Mr. Market in “The Intelligent Investor”, shows a bipolar organism with a mind of its own that is not telling anyone what it is thinking. Mr. Market prices stocks at sometimes wildly different prices each day, and Graham summarizes with:

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies”.

It is great advice but one that comes with a caveat. You must, independently of everyone around you, determine the state of Mr. Market. Is he sick or is he getting better? Don’t take the word of anyone that stocks are cheap or that they are overvalued. You need to determine these questions yourself, in your own mind, grasping the facts for what they are. Graham talked a lot about security analysis of an individual equity, but you must also understand or comprehend or have a very strong belief in the markets valuation. If you are unsure of overvaluation or undervaluation, you are setting yourself up for major problems and potential losses. This is also part of the scrutinizing known as security analysis.

One of the overlooked books regarding Benjamin Graham is “Benjamin Graham, Building a Profession”. At the end of the book, Graham is being interviewed and was asked the question regarding the 1929 Great Depression in which Graham lost a fortune, “Did you see that coming at all….were you scared?” Graham replied, “No, all I knew was that prices were too high. I stayed away from the speculative favorites. I felt I had good investments….” Graham went on to lose a lot of money during the depression, but came roaring back later.

My own experience over the last few years has been an interesting conglomeration of experimenting in areas that I was mostly unfamiliar with. Value investors are able to find value in several ways. Some will invest in companies that are near bankruptcy or even post-bankruptcy. Others may choose mergers and acquisitions, distressed equities, fallen angels, spinoffs or even the old cigar butt style of Graham, the ideas for finding value only limited by ones imagination.

I recently arrived at my own liking for short-selling stocks. I have had mostly success, but it has not been without bumps and bruises along the way. It’s not that I don’t have mostly long positions. I do. Because I concluded that stocks are generally overpriced at the present and that the market was mostly being fed….well by the Fed, it was time to consider alternate investments. I concluded a few things as I studied the short-selling concept of investments:

1. They are definitely not for everyone. In fact, unless you are an extremely patient investor, my recommendation is to completely steer clear of the notion of adding this to your repertoire of investing possibilities. I cannot emphasize that enough. As a 61 year old man with a four year old daughter, I fall under the description of being extremely patient along with the nerves of steel to go with it!

2. Contrary to many opinions, short-selling is a methodology completely consistent with value investing. Articles abound as to why it is not, but I view it as not vastly different from those that go after distressed stocks or bankruptcy stocks with the belief that a turnaround is ahead for those that can be patient. While Seth Klarman, to the best of my knowledge, does not short stocks, he does invest in many value situations that many other value investors stay away from.

Seth Klarman has repeatedly remarked that short-sellers have their place. In fact, Klarman stated, “Many Wall Streeters have a different view of short-selling. They believe that short-sellers are dangerous manipulators of security prices driving prices down for their personal financial gain. This prejudice against short-sellers is consistent with Wall Street’s interest in maintaining high stock prices”. Margin of Safety

But the position of short-selling could not be more clearly enunciated as it is by James Montier in Value Investing:

“It never ceases to amaze me that whenever a major corporate declines, the short sellers are suddenly painted as financial equivalents of psychopaths. This is madness, rather than examining the exceptionallypoor (and sometimes criminal) decisions that the corporate itself took, the short sellers are hauled over the coals”.



“My own bottom-up valuation works finds opportunity for investment at the moment. This suggests to me that the main opportunities may lie on the short side in the current market. So I guess I am joining the ranks of the dark side!

“The most fundamentally oriented analysts I have come across are without a doubt the short sellers. These guys, by and large, really take their analysis seriously (and so they should since their downside is effectively unlimited)….Rather than being some malignant force within the markets, in my experience short sellers are closer to accounting police.

Consider what a short seller is doing. They are attempting to demonstrate companies that are being run poorly through ineptitude, perhaps criminally. While companies may be unhappy with those that point out their weaknesses, nobody seems to mind when analysts find strong companies. Ultimately, it allows the market to correct what is an unjustifiable look at an equity and correct itself by withdrawing funds from the stock and providing capital to those that better deserve it.

David Einhorn explained that it is nothing more than investing long on those stocks that are undervalued and shorting those that are extremely overvalued. He discerned that, “I’m not critical because I’m short; I’m short because I’m critical”.

3. Further, having steeped myself deep into the thought process for analyzing companies that may be potential candidates for shorting, I have also developed a process for “killing the company” as Bruce Berkowitz would advocate or more specifically, a checklist has been developed for screening potential short selling stocks that require deeper research. It may not be a potential short candidate, but it allows me to understand the strengths and weaknesses the business might have to overcome if one chooses to go long or at least decide to remove it from a list of potential stock ideas.

4. Having read many of the arguments for and against short-selling, most of the arguments are not fully thought out, coherent or are extremely naive, as if the author wants to scare you away from consideration. To state that the losses are unlimited because there is no limit to how high a stock may rise, is to assume that there are not reasonable ways to protect yourself.

5. While short selling may not be a strategy that is best for all, it is incumbent for us to understand that each and every stock has both a bear case and a bull case or a long thesis and a short thesis. All stocks, without exception. It’s advantageous to understand those positions prior to going long or short and without taking it personally. We should learn from the long and short positions rather than being insulted by them. I happen to be short International Business Machines Corp. (IBM) and have been for some time. I have actually done quite well thus far. Without going into details for the short thesis, does anyone think that Warren Buffett’s feeling are hurt by my short or anyone else’s because of his large “long” position. It is doubtful that he cares, except that he might increase his position as the stock continues to go down. It’s not any different than buying a car and checking with the competition to see what the opposite side thinks. Learn from it.

Taking the lead from short sellers such as Jim Chanos, David Einhorn, James Montier, Doug Kass, John Del Vecchio and others, a checklist or parts of my shorting criteria will be provided in a future articles, indicating how one might consider all sides of analysis and/or at least provide some insight how a short seller might view a stock that is being considered for an investment. Further, some guidance as to why you might short or not short a stock will be offered.

Disclosure: Short IBM

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

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