My Thoughts on Shorting

January 2, 2018

Yesterday, someone asked me: “What are your thoughts about shorting some super-heated stocks that are just barely avoiding a reality check, i.e. over-valued stocks emotionally purchased and propped up by the tax cuts?”

Here is my response (slightly edited to improve grammar and readability):

You ask a great question and this is one I have thought about and been tempted to do many times (and will continue to be tempted to do)! As you may have heard before, I follow a few short sellers and read their reports regularly.

Shorting is not simply the opposite of value investing. In value investing, we find undervalued stocks that will rise over time thanks to catalysts. All you need is to be patient, and the chances are very good over the long-term that you will be rewarded if done correctly, or not lose a large amount of money if unfortunate events occur.

With shorting, there are higher costs, mainly borrowing costs for the stock (ranging from about 2%-30% per year depending on the availability of the shares for shorting) and margin interest if there isn’t enough cash in the account. Timing is very critical in shorting unlike value investing. A stock that is overvalued can get more overvalued. So far, many famous investors have been burned from shorting Tesla and Amazon. If the price goes against you in the short term, you will be required to add more capital or lose the risk of your broker forcing you to reverse your short. I recommend reading the book “When Genius Failed” by Roger Lowenstein, where Nobel Prize winners, PHD’s and investment experts lost a lot of money from shorting. 

From observing profitable shorts by famous investors, the better opportunities are not in overvalued stocks, but those companies that are potentially fraudulent. As an example, I believe Cemtrex is a great short idea. I asked my custodian what the borrowing costs are for Cemtrex and it is 27% per year! That means you need Cemtrex to collapse in less than 4 years to make money. Enron’s fraud lasted for decades, so these things can take a long time. Therefore, the borrowing costs for Cemtrex are too high to make the risk/reward tradeoff attractive.

I do, however, recommend shorting Bitcoin. It’s a great short-term play with minimal costs when you sell a futures contract. You just have to be willing to commit a large amount of capital, which I’m not willing to do. With value investing, it’s not gambling, because you are investing in a real business with a certain margin of safety. In shorting Bitcoin, while the odds are high you will make money, I consider it gambling, because it is based on my subjective opinion that the price will go down, and there is no real way to value Bitcoin. Bitcoin’s ultimate price will be driven by the collective opinion of the market, which means logic has little influence on price.

Moreover, when I look at the most successful investors, most of their profits come from being long and not short. 

Shorting can be profitable, but it’s a different game. Value investing is like Texas Hold’Em Poker, while shorting is like Omaha Hi-Lo. It’s similar, but different. Mastering one game doesn’t make you a master in the other. One must exert the same amount of effort and time (at least 10 years) to master the other game. 

I also think researching short ideas are harder, assuming you go hunting for potential frauds. There is a lot of investigative legwork necessary. You need to have a large team doing field work like FBI investigators. More importantly, to increase your profitability, you need to broadcast your short, influence others to follow, and withstand criticism from major parties. Because of costs, time is against you, and most people do not have the psychological and emotional character to make sound decisions against the immense pressures of shorting.

If you would like to short, I recommend piggy backing Muddy Waters. When they release a report, follow their trade ASAP. I think you are likely to make money (I am tempted to do this for my personal account, but will refrain).

Finally, I think you’ve come to know that I am very long-term oriented and defensive, so I worry that if I get my first 2 shorts correct, I’ll continue doing it and will lose more money on future trades. When you have one potato chip, it’s hard to stop! I’m worried that I’ll get overconfident. The best safeguard for me is to just not do it. While I’m taking away the potential for higher returns, I am decreasing the potential of losing money in the decades to come. I intend to sharpen my skills in one game (the safer and more profitable one) than spread it out over two.

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