The question about whether to short or not, is common among value investors (as well as non value investors). We think that there are many opportunities for value investors to find gems on the short side. The inspiration for this article comes from Kyle Mowery of Grizzly Capital. Kyle made a list of ten reasons why value investors should not short stocks. We want to play devil’s advocate, so we list some of his points below and respond. The point of this article is not to argue with Kyle, he makes good points, we want to prevent the other side of the argument. Below we list the top five reasons why value investors should consider shorting stocks.
1. Legal Restrictions: A large majority of assets are managed in “plain vanilla” mutual funds which do not permit managers to short securities.
The statement above indicates that there are more opportunities for those on the short side. Since there are few restrictions on long only investments and far more limitations on the short side, its easier to find ‘value’ on the short side. In a similar vein, since sell side analysts tend to only have ‘buys’ on most equities, there is scant research on why a company could be a good short. Less coverage usually equals more opportunities, which is a reason why many value investors like to search the small cap area.
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.
The fact that many value investors do not short sell, makes the case for shorting even stronger. For a value investor, the biggest enemy (besides themself) is not quants, macro guys or technical guys, but other value investors. Since most value investors are long only, there is more value in the short area. Value investing’s popularity has grown incredibly over the past 15 years or so. Many times while looking for bargains other investors will have already boosted up the price of those assets. If few value investors are looking on the short side for investments, this means it is even easier to find overvalued (or fraudulent companies).
3. Shorts can only make 100%
This is a good point, but Jim Chanos has a good counterargument as to why he disagrees. Chanos states “I’ve seen a lot of stocks go down 100%, but I’ve yet to see a stock that went to infinity.” We agree, and furthermore we see few stocks go up 100% in a short time period. Value investors are in for the long term, if a stock appreciates 12% a year, it takes six years to make 100% return, and that is still considered good. Shorting can make large returns in the same or shorter time frames.
4. 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 to manipulate “encourage” higher share prices by focusing on a company’s positive attributes.
This is great for short sellers; as long as someone can make sure they can add to a short and have enough money to stay solvent. Management can manipulate prices for many years, but eventually it all comes flying down. It is hard to get the timing right, but even if you do not, eventually the stock caters. Ackman ‘shorted’ MBIA in 2002, but it did not collapse in price until 2008, at which point he made a profit of over $1 billion.
5. Borrowing shares is expensive:
This is true and a very valid point. However, the more crowded a trade is, the more expensive it is to short, and the more likely it is that there is too much competition on the short side. The very inexpensive shorts can be very profitable.
A good example of this is reverse Chinese RTOs; the first short sellers entered in 2009 or so, and made a killing. However, the field became very crowded over the past year, and returns have not been great. Carson Block of Muddy Waters, who was one of the first short sellers of these stocks, threw in the towel recently.
Disclosure: The author of this article rarely shorts, and sometimes hedges. No position in any securities mentioned.
