“We don’t like trading agony for money.”
— Charlie Munger on short selling, Berkshire Hathaway 2013 annual meeting
Many long-only investors often come across companies that appear grossly overvalued by any objective standard. In fact, in most market environments, it is quite a bit more likely to run into seemingly overvalued situations when using metrics commonly favored by value investors. Since the number of companies within a typical investor’s circle of competence is a small subset of the overall market, it seems quite tempting to be able to act on all situations where one has a strong opinion rather than being restricted only to buying undervalued stocks. However, long-only investors who take a naive view of short selling as merely being the “opposite” of going long will most likely quickly learn about the kind of “agony” Charlie Munger referred to at Berkshire Hathaway’s 2013 annual meeting.
Amit Kumar, founder of Artham Capital Partners, recently published Short Stories from the Stock Market, which serves as a guide for value investors who are interested in broadening their horizons beyond a long-only strategy. The book provides a research framework that can be used to identify actionable short ideas while avoiding situations that, on the surface, may appear to be attractive shorts but really represent a minefield. The nature of short selling is different from buying stocks because losses are theoretically unlimited while gains are capped — the opposite of being long on a stock. This asymmetry requires the addition of several steps to limit downside risk.
One common mistake involves shorting a stock based only on a high valuation. Since many long-only value investors are willing to commit capital without requiring a specific catalyst, their instinct when exploring short ideas may be to assume that a ridiculously high valuation is a sufficient rationale. In reality, a high valuation is typically a necessary condition but it is usually not sufficient.
If high valuation is not a sufficient rationale for shorting a stock, how does one go about identifying opportunities? Ideally, a short candidate might have an unsustainable business model or be run by unethical managers who have used fraudulent methods to misrepresent the results of the business. While correctly identifying a fraudulent company may reveal the perfect short, looking for more mundane situations like broken growth stories can also yield potential ideas. It is common for successful long-only investors to attempt to “kill an idea”, as Bruce Berkowitz often suggests. It is possible that a company initially researched as a long opportunity could become a short candidate if the process of “killing the company” reveals severe weaknesses.
The book provides useful case studies regarding companies that were targets of short sellers including certain examples that remain unresolved to this day. The Herbalife example is very recent and covered well in the book. Herbalife is particularly interesting given that very highly regarded investors have taken opposing positions on the stock. A superficial review of Herbalife would not lead one to think that it is grossly overvalued. The shorts do not base their thesis on valuation but instead allege that the company is essentially a fraud and have encouraged regulators to examine the company’s business practices.
Most readers would do well to listen to Charlie Munger’s advice regarding short selling. Even in a market near record highs, there should be plenty for most investors to do on the long side particularly for those who have the flexibility to look at smaller companies. Furthermore, it is perfectly fine to simply accumulate cash if the market is so high that opportunities are scarce. However, for those investors who are willing to take on the challenge of short selling the rewards can be enormous assuming they understand the risks. Short Stories from the Stock Market succeeds in its mission to provide aspiring short sellers with an intelligent framework to pursue opportunities with their eyes fully open when it comes to the risks of doing so.
Disclosure: The Rational Walk was provided with an electronic copy of the book for review purposes.