Value investing is not a long-only philosophy.
Yet many value investing practitioners exclusively choose to go long and shun short-selling.
That’s fine and I’m not one of those bloggers who likes to belittle the strategies of others like an unknown bulletin board poster.
Its just that if markets fall faster than they rise, it would make sense to try and capture the returns that shorting has to offer.
The following chart is typical of what I’m talking about:
You can see how long it took for 3M’s share price to rise from $41 in March 2009 to $97 in July 2011. A gain of 136% in 29 months. But from July 2011 to September 2011 the price fell from $97 to $71. A drop of 26% in just under 3 months. You can see this as a dramatic spike down in the middle of the chart. You should also be able to discern how fast the price fell.
This is what I mean by markets falling faster than they rise.
So is it possible for a value investor to take advantage of these opportunities?
But first, let’s take a look at the 2 main reasons why shorting is considered taboo among value investors.
- Shorting by its very nature means the use of leverage – this is possibly the #1 reason why a lot of value investors do not like going short. Its built into the fabric of traditional value investing philosophy that the use of leverage is simply evil because it can wipe you out. And it can. Using leverage without knowing what your potential total exposure is means financial suicide. For example you can lose more money than you have in your brokerage account if you don’t know what you’re doing. Ending up as a debtor to your broker is the worst place that an investor can find themselves in.
- Shorting could mean that your losses are unlimited – this is another biggy that traditional value investors use as a case against shorting. Think about it. When you buy stock/go long you know exactly how much money you could potentially lose; your stock could go to zero. If you go short and your stock continues to rise – who knows where it will end up, all the while your losses will be exacerbated due to the use of leverage.
Since the philosophy of value investing has the concept of low-risk built into it, its no wonder many value investors advise against shorting stock.
It appears then that if a value investor can control leverage and limit liability, then the risk of shorting can be reduced to the extent that value investors can use short selling as part of their strategy.
For a case study on how I recently achieved this, take a look the following 2 articles:
The articles will show why I wanted to short Amara Mining (AMA) and how I limited liability by determining a stop-loss level BEFORE initiating my position.
This very act ensured that I knew how much I could potentially lose from this investment. This resonates with the philosophy of value investing which among other things seeks to reduce risk.
Clearly in the case of Amara their fundamentals are just terrible.
Risk reduction was also achieved by use of a smaller position size and the Amara article talks about the reasons why this was necessary.
I can’t escape the fact that short selling is financially dangerous to the uninitiated and the usual caveats apply. Newbie investors should first use a long-only approach and master it by gaining experience before attempting the short-side.
Just a quick update on the things that may affect your interaction with me and the Shares and Stock Markets Blog:
1. Google are turning off Reader
Because Google are discontinuing with their Reader service and if you get updates to the Shares and Stock Markets Blog from them, you should switch to an alternative reader today. The general consensus is that feedly.com is the best alternative to Google Reader because you can sign in with your Google Reader details and feedly.com will import all of your feeds to their service.
It’s also free.
They’ve produced a handy guide for Reader users who want to migrate their settings over which you should access here now.
If you have an Ipad I suggest using Flipboard if you’re not already.
2. Google will probably turnoff Feedburner
Despite the awesome efforts of the people behind Please Don’t Kill Feedburner, the general consensus in the blogosphere is that Google will also terminate Feedburner which will have enormous consequences for bloggers. My solution for the Shares and Stock Markets Blog is a separate subscription just for updates which can be found here.
The Shares and Stock Markets Newsletter will remain a separate and distinct subscription by providing content that is not published to this blog.
Thanks for reading.