Tuesday, December 16, 2008

Some Thoughts on Short-Selling

With the backdrop of this year’s historic short-selling successes, I was recently asked why I rarely engage in this practice.

After thinking about it for a while, my answer is basically this: It is too difficult to be consistently right on timing and other factors. Timing matters much more with selling overvalued assets that you expect to depreciate, as opposed to buying undervalued assets that you expect to appreciate.

Over time, stocks generally increase in value, and holding long-term short positions is costly. Moreover, the possibility of unknown, intervening events gives shorting a different risk profile: for example, a weak company might get bought out, leading to a dramatic increase in the stock price.

Sharp surges in price are much more dangerous for the short-seller than are sharp declines for the stockholder. In the latter case, if one does not use margin, volatility scarcely matters as long as the equity remains attractively valued and the fundamentals have not deteriorated.

By contrast, to look at successful short-sales, consider that Bill Ackman had been short MBIA since 2002. In other words, he thought it would fail during the last recession. He took losses over an entire business cycle for the company to finally break down. David Einhorn waited a similar period of time with Allied Capital, as the stock rose smartly.

You can't get a margin call on equity. Or, in other words, the reverse of shorting is buying equity on margin. Imagine buying a stock at $50 and having it drop to $20 – being forced to sell – and then having the stock sharply rebound. This type of thing happens with shorting all the time, making it dangerous to short technology stocks or commodities or whatever else. Highly overvalued assets can get insanely overvalued, long enough for you to get tapped out.

The other option, no pun intended, is to use puts. The problem here is that equity doesn't expire worthless. But with puts, you can be exactly right with your decision, wrong on timing, and the put option expires worthless. (And then, the next day, the stock plunges to $0.) In my view, anything time-sensitive is absolute rat poison, unless the terms are exceedingly generous.

You want to look at it the way Warren Buffett looks at insurance: unless rates are incredibly appealing, relative to risk, then you simply do not write business. As he says, success at investing is all about temperament. The best action is often to take no action at all.
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This work by Nicholas E. Radice is licensed under a Creative Commons Attribution-No Derivative Works 3.0 United States License.