Shorting Strategy and Value Investing  

How does shorting work?

Shorting strategy has been very popular since the bubble burst of technology stocks in 2000. Shorting a stock is simply a bet that the stock price will drop.

An investor can sell a stock he/she does not own by borrowing shares from brokers. The investor can sell the stock first and then buy back the shares at later time. The investor can make profit if the stock price he/she sells is higher than the price he or she buy back later on.

. The core task of a value investing is to calculate the intrinsic value or the worth of a stock in order to identify bargain stocks that are trading at discount to their intrinsic values. If a successful value investor can buy cheap stocks based on their intrinsic value, why not just short a over-priced stock? In the end, method for calculation of intrinsic value is same whether the stock is overpriced or underpriced.

However, if you read carefully the value investing books from Benjamin Graham, the father of value investing, you can find very little information on shorting. We also know that Warren Buffet himself does not utilize shorting method. So why is shorting strategy not used by 2 greatest value investors in history?

Shorting Strategy for Value Investors? At appearance, shorting strategy should work well with most value investors

Shorting Requires Higher Degree of Diversification

Mutual funds are known to have extremely diversified portfolio of hundreds to thousands of stocks.

Many successful value investors invest into concentrated stock portfolio with adequate diversification. In the book Intelligent Investor Chapter 5 titled "the Defensive Investor and Common Stocks", Benjamin Graham preached "adequate diversification" of 10 to 30 stocks, but not "excessive diversification". Warren Buffet was also known to invest into portfolio of less than 20 - 30 stocks for his hedge fund in earlier years and for his firm Berkshire Hathaway. Charles T. Munger, the second man of Berkshire Hathaway, and a great billionaire value investor himself, was also known to make even more concentrated bet than Warren Buffet when he was alone managing his own hedge fund before he joined Berkshire Hathaway. My past investment performance in Blast Investor Real-time Plus newsletter was also obtained with concentrated portfolio of around 10 stocks as well.

However, this kind of concentrated portfolio common in value investing world would not have adequate diversification with shorting strategy. To illustrate this point, I put following 2 hypothetical cases for comparing a typical long-only value investing portfolio and a short-and-long combined portfolio.

Case 1 - Long Only Value Investing Portfolio

Table 1- Portfolio 1, Long Only Portfolio

Stock Long or Short $ USD for stock position

1 long $10,000

2 long $10,000

3 long $10,000

4 long $10,000

5 long $10,000

6 long $10,000

7 long $10,000

8 long $10,000

A long $10,000

B long $10,000

Total Equity $100,000

Table 1 is fully invested hypothetical portfolio with 10 stocks. All the 10 stocks are long position of bargain value stocks. Suppose for the 2 years, 1 to 8 stock price stayed flat with no gain and no loss, and stock A and B each lost 90% of their value in the first year, and then not only regained all the losses in the second year and actually doubled from the original entry price. Table 2 is performance of portfolio 1 for this 2 years:

Table 2 - Performance of Portfolio 1

Stock Initial Year1 Year2

A $ 10,000 $1,000 $ 20,000

B $ 10,000 $1,000 $ 20,000

Portfolio1 $100,000 $82,000 $120,000

Portfolio1 Performance NA -18% 46,34%

90% of loss in 2 of 10 stocks in portfolio did not kill the 2 year overall performance of portfolio 1. In fact, Portfolio 1 still enjoyed overall 20% gain over the 2 years.

Case 2 - Long and Short Portfolio

Table 3- Portfolio 2:

Long 8 Stocks, Short 2 Stocks

Stock Long or Short $ USD for stock position

1 long $ 10,000

2 long $ 10,000

3 long $ 10,000

4 long $ 10,000

5 long $ 10,000

6 long $ 10,000

7 long $ 10,000

8 long $ 10,000

X short $ 10,000

Y short $ 10,000

Total Equity $100,000

Table 3 is fully invested hypothetical portfolio with 10 stocks. All 8 stocks (stock 1 to stock 8) are same long position of bargain value stocks, and Stock X and Stock Y are short positions. Suppose for the 2 years, 1 to 8 stock price stayed flat with no gain and no loss, and stock price X and Y each increased 10 times in the first year, and then not only lost all the gains in the second year and actually further crashed and cut in half from the original entry price. Table 4 is performance of portfolio 2 for this 2 years:

Table 4 - Performance of Portfolio 2

Stock Initial Equity Year 1 Equity Year 2 Equity

X short position $ 10,000 -$90,000 $ 15,000

Y short position $ 10,000 -$90,000 $ 15,000

Portfolio2 $100,000 $ 0 (wipe out) $ 0 (wipe out)

Portfolio2 Performance NA -100% -100%

Although the investor correctly predicted that stock price of X and Y would drop in 2 years, the first year rise of 10 times in stock price of X and Y triggered margin call in portfolio 2. The 2 short positions of X and Y wiped out the whole portfolio 2 so that the portfolio never had a chance to profit in the second year of dramatic crash of X and Y stock price.

Market Timing and Money Management

Although the above -90% loss and 10 times rise hypothetical cases are not common, this kind of wild ride in stock market did happen. A stock price change from $1 to $10 or from $10 to $1 was even less rare in small cap or micro cap market.

A prudent investor certainly can not rule out such possibility in portfolio management. Long term oriented value investing with 10 stocks can certainly withstand this kind of losses in case 1. However, the same kind of change would not have chance of surviving for shorting strategy as shown in case 2.

To avoid wipe out with short strategy, investor has 2 choices:

Investor either has to have a more diversified portfolio, possibly with hundreds or thousands of stocks just like a typical diversified mutual fund portfolio.

or Investor would engage in short term trading or market timing so that the investor can short at or near top to avoid wipe out risk.

Neither of above 2 choices are attractive for a truly successful value investor. First of all, concentrated bet without excessive diversification is one of key reasons for high performance. With hundreds or thousands of stocks under management, a portfolio with short strategy would be as mundane as a typical mutual fund portfolio in terms of performance. Second of all, value investing method is price oriented long term investing method, which by itself is at odds with any market timing or short term trading strategy.

Certainly, there are successful investors utilizing short strategy in stock market. However, here is my final 5 cents as below:

Great value investors such as Warren Buffet and Ben Graham do not short, you don't need to either.

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* Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut. Visit http://www.BlastInvest.com for FREE "how-to" investing assistan

Plan your budget before investing on a property

Owing a property gives a person financial security but before buying any type of property be it home,land or some commercial property it's very important to estimate your budget.Pre-qualification is a very essential step in going for a property deal. There are various ways of pre-qualifying but good idea is to get help of a lender before you even start to look for a home. Pre-qualification lets a buyer know exactly how much a lender is willing to loan him and helps the buyer to save a lot of time, money and even your efforts will be in right direction. Often the first time buyers get puzzled about the estimation of their mortgage payment that they will be able to handle each month. They even have to decide how much money they need for a down payment and closing costs. That's why it is advisable to meet the lender before going any further. Pre-qualification does not obligate buyers to take a loan from the lender, nor should it involve any fees. Until the buyer actually go for the loan.

Another way of pre-qualification is to meet some good real estate professional and get his advice. This is not compulsory but can be considered as one of the good methods to be followed in pre-qualification. Real estate agents help the buyer more easily as they are the people who constantly monitor the market scenario. The market trends are clearer to them and even they have large contacts in financial institutions which can help the buyer. Usually pre-qualified buyers have an edge while making a deal with the seller as he knows that there is some lender ready for making the deal to happen. It helps you to negotiate the deal on you terms and make it more flexible.

When the lenders pre-qualify they are more concerned about the paying capacity of the buyer. With that the lenders also check for the other debts the buyer has or what is the monthly expenditure of the prospective buyer. There are different methods of deciding for the loan by the lenders. Loan plan is done according to debt-to-income ratio. In case of higher debt-to-income ratio one factor that influences the lender to allow loan to the buyer is more downpayment.Usually the debt-to-income ratio is between .28 to 1 and .38 to 1. The general theory in lenders circle is that a person who has invested more in the purchase is less likely to be a defaulter .What buyers usually realize that the pre-qualification process will produce a home purchase price that is roughly 2 to 3 times their gross annual income. Since the lender's calculations will also consider a buyer's actual debts and ongoing expenses, the loan pre-qualification amount may be higher or lower.

For any further information: property dealers and online real estate

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