While a value investor, especially one of the deep-value variety, will be no stranger to plumbing unpopular and unloved sectors for opportunities, the flipside often presents a different set of challenges: Simply being certain that a stock is overvalued – or doomed for eventual collapse – is not enough. A different sort of patience is required when trading a stock that looks overvalued, but remains loved by the market.
The stock market may be a voting machine in the short run and a weighing machine in the long run, as Benjamin Graham once pointed out, but the time it takes for the long run to emerge may prove interminable.
In today’s research note, we discuss the trap that often catches short sellers: shorting on the basis of valuation alone.
Catalysts are key
The principal difference between the short and long side is that, while a long thesis can be built effectively and confidently on the basis of valuation (the market is undervaluing assets, earnings, future performance, etc.), the same cannot be done quite so easily with the short. Sure, the valuation may inform the decision, but it is often not enough.
A number of top players in the short game have shared their thoughts on the need for catalysts to make a short position work:
"A basic principle in going short is that there has to be a catalyst." – Steven Cohen (Trades, Portfolio), Point72 Asset Management.
“I need to have conviction in all my shorts about either a company specific catalyst or a macro catalyst.” – Whitney Tilson (Trades, Portfolio), Kase Capital.
“While we love catalysts on the long side, we require them on the short side. Valuation shorts are always tricky.” – Shawn Kravetz, Esplanade Capital.
These three quotes offer a very nice encapsulation of the asymmetry between long and short investing and the inherent importance of catalysts to the latter strategy.
A short trade based on valuation may not lead anywhere for a long time. What really kicks off a share price correction, and thus a profitable short, is a catalytic event. Catalysts come in many shapes and sizes, but all are important to short strategy for a specific reason: It takes a big event to shake loose market confidence sufficiently to see the stock price tumble – and keep tumbling.
Without a catalyst, the short seller has to hope the market comes to its senses by reason alone. That can prove to be a dangerous proposition.
Jaguar in the tree
So we understand the importance of catalysts in general to successful short trades. But when do we know the time is right?
Legendary short seller Marc Cohodes presented one of the most famous guides to timing a short entry point:
“I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I'm interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground.”
A stock that has been bid up massively, or is otherwise grossly overvalued, is like the jaguar in a tree. It has fierce defenses and climbing after it (i.e., opening a short) is an invitation to get clawed and mangled. When the catalyst hits and sentiment really starts to shift, then it is time to pounce. The jaguar will eventually be starved out of the tree, making it far less dangerous prey.
When not to pounce
At this stage, it should be fairly clear that the success of a short position is often dependent on good timing. That does not simply mean knowing when to open the short, but also when not to do so. Hedge fund guru David Einhorn (Trades, Portfolio) offered some solid insight with regard to this latter scenario when discussing his hedge fund’s unwillingness to short the last big tech bubble, even when it hit ludicrous highs:
“For the most part, we avoided the damage in the short portfolio [in the tech bubble] by refusing to sell short anything just because its valuation appeared silly. We reasoned that twice a silly valuation is not twice as silly. It is still just silly. Kind of like twice infinity is still infinity.”
When the market is being hugely irrational and bidding up prices to stratospheric levels, it may be tempting to open a short. But without something to prick the bubble or knock the rocket back to earth, there is no inherent reason to expect the irrational exuberance to stop. One insane valuation can beget another, and a short seller caught in an upward charge can lose badly long before the final correction proves them right.
Act with care
Investors must be wary of overcommitting when the timeline is uncertain. Things rarely are certain in the stock market. So, even if you have absolute conviction about your thesis, act with caution lest you lose out before the fall occurs. If a thesis is correct fundamentally, it will eventually bear fruit.
You must have patience and possess the ability to endure the market moving against you for a time if you expect to succeed in the endgame.
