A Value Investor's Take on Shorting

A few weeks ago, I received a question from a reader:

"Would it be possible for you to do a post outlining what you’ve read and/or what your thoughts on shorting are? I know its sort of frowned upon in the value community so I thought it would be interesting to get your perspective and what you’ve read of others on the matter. Perhaps you could also discuss how you would evaluate the tradeoff between going long put options and shorting a given security outright?"
18 or so months ago I wrote a post entitled: "Distressed Debt Investing's Book Recommendations: Equity Shorts" in which I recommended and gave summary reviews on five books dedicated to the practice of shorting.  And when I was just a wee little (with one of my first posts), I wrote about how I approached shorts from a fundamental research standpoint.  While I wasn't short DRI at the time of the post, it turned out to be a pretty decent short for short time being down 10% versus the market up 20% a few months later.  To be frank, a lot of my thinking around shorting has evolved since that post.  With that said, I do stand by this passage:
"You make money in the market by having different expectations about the future than the general consensus. If you think 2010 and beyond free cash flow will be substantially higher than the analyst community, you would be more apt to buy the stock."
One of the reasons shorting has a stigma in the value investing community come from comments Seth Klarman (among other prominent value investors) made about the asymmetric upside and downside that shorts impose on funds.  Here is a chart that haunts a number of the best funds in the world (and a few analysts that got laid off because of it):

This is the chart of Volkswagen which is one of the greatest, if not the greatest short squeezes in recent investment history.   For those looking for the back story, simply Google: Volkswagen hedge funds

Equity shorts have unlimited downside and finite upside (100%).  With that said, in a very old letter to investors, Seth Klarman wrote:
"Of course, diversification is for us only the starting point for risk reduction. Solid fundamental research, emphasis on catalysts, value discipline, preferences for tangible assets, hedged short selling, market put options and other strategies combine to create an overall portfolio safety net for our portfolio that we believe is second to none" (my emphasis added).
No where there do I read Klarman being 100% against shorts:  Just shorts that expose him to infinite loss.  

Personally, I very rarely put on naked short positions in my personal account.  Given the size, I can be much more nimble than a large fund.  With that said, more often than not, I am employing three distinct strategies:
  1. Shorting a stock while buying a way out of the money call on the name.  While I give up some performance, my downside is capped (and even if my position is not 100% delta hedged correctly, potential loss is significantly reduced)
  2. Bearish vertical call spreads.  I use this strategy more when the borrow is tight (enormous rebate) or impossible to find at one of my brokerages.  In this scenario, I will often sell at the money calls, while buying calls further out of the money.  I am taking a directional bet that both positions will expire out of the money.  In this scenario, your loss is capped at the difference between the strike price of the two contracts used * number of contracts * 100. 
  3. Buy puts.  This is highly dependent on things like implied volatility of the various puts, as well as the tenor, liquidity, and strike prices.  It is also highly dependent on being able to put to a catalyst to get the position moving to offet the premium which might be quite high given the volatility or lack of borrow in the name.
While my thinking on this has changed over the past few years as an investor, I will never short a company on valuation alone.  Unless there is a catalyst, I simply do not want to get involved.  The one exception to that are companies that have no chance of survival based on a flavor of the month technology - Does anyone remember the old Raser Technologies?  While I will not name a specific name tonight, currently I am short a renewable fuels company as well as a company involved in stem cells.  In effect, the business models of these companies are broken because they cannot survive (make payroll) without extensive infusions of capital (i.e. a ponzi scheme).  

The shorts I REALLY like (outside China reverse merger frauds) are the ones where quality of earnings is remarkably weak or there is some other kind of accounting irregularity. This is where diligent analysts separate themselves from the crowd.  Even better when short interest is low, there are many buy versus hold/sell recommendations, and seemingly you are the only one that cares that inventory is growing much faster than sales, or the company is the only one in its industry using FIFO (which hurts in down markets), or a company has changed an accounting assumption like depreciable life.  I also love when I see completely misaligned incentives between management and shareholders.

Credit and equity shorts are fundamentally different in many aspects.  For instance, I can be short a BBB credit via CDS and do very well if the company gets LBOd.  If I was short the equity, it would have been painful.  CDS also benefits from a more manageable risk/return profile as credit spreads can't go to zero and expose investors to infinite loss.  Further, shorting bonds is treacherous in the borrow can be pulled with a snap of a finger and the propensity for a fund to do this that is establishing a large position to gain control of a situation is high.  It has happened to me in the past and its devastating (not to mention the high carry costs).  CDS also has the added benefit of being high leveragable with the minimum ticking costs versus the extreme payouts.  Just ask Bill Ackman, John Paulson, or Mike Burry.

It is my estimation that an individual investor need not use hedges to protect against market uncertainty.  Instead, if you deploying 6 figures of capital or less, you should taking negative positions (using one of the three strategies I noted above) in individual names.  If you are right on your due diligence, and the story is indeed negative, it would take an awful lot of tide turning for these individual stocks not to go down in an overall down market.  If you are truly worried about the market, and can't fight individual stocks to hedge with, you probably should be out of the market waiting for the fat pitch.  But in my thinking, every individual investor out there can turn over a few stones and find a few stories to short.  Maybe its a company in an industry you know well or possibly a company whose management team sank the last ship they were a part of.  If everyone thinks the company is overvalued, that might not be your best bet (market hurts the most people at any one time - pain trade is higher in that scenario).  Instead look for situations that are fundamentally misunderstood (or a fraud) where there are a lot of cheerleaders who have no idea what they are doing, and that can be hedged as to not risk an financial ruin EVEN if you right in the long-run.  


Anonymous,  3/13/2012  


Anonymous,  3/13/2012  

I would guess AMRS

Pacioli,  3/13/2012  

"For instance, I can be short a BBB credit via CDS and do very well if the company gets LBOd."

I guess I don't follow how this could be possible. If the company gets LBO'd, won't the credit (which you are short) be paid off at par, therefore hurting you?

Thanks in advance.

another value investor 3/13/2012  

"Bearish vertical call spreads."

Could you elaborate why you would use bearish call spread instead of bearish *put* spread? Simply because you get money up front?

Anonymous,  3/13/2012  

@ Pacioli - that would be a risk if you were shorting bonds directly (and they were trading below par when you shorted them) but CDS don't get paid off. rather they would get repriced to reflect the new senior unsecured or whatever obligation. the only risk would be that the LBO financing was structured such that the CDS you happened to own had no reference obligation, but that's unlikely for typical CDS contracts.

Simon,  3/17/2012  

Investment grade bonds do not get refinanced as the sponsor will leave them outstanding due to very loose language in those bod indentures. If those bbb bonds were lbo'ed the price will fall to reflect the additional debt expected to be incurred.

anahin 3/19/2012  

Anahin (www.anahin.net) gives a complete Graham analysis for all 4000 stocks listed on the NYSE.
(Ben Graham was the mentor of Warren Buffett and the pioneer of value investing)

Graham's own take on speculating, including shorting, was that one can say with near certainity what would happen to a stock, but not when.


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.