The idea that what you pay (price) can deviate significantly from what you get (value) in the short term underpins our investment philosophy. We believe that we can profit by taking advantage of this discrepancy. So far our positions have consisted exclusively of long positions, where we buy a stock at a price under our assessed value and hold until its price converges to its value. This isn’t to say that we don’t encounter countless stocks which trade at significantly higher valuations than we consider reasonable. In fact, overpriced stocks seem to be – at least in the current market – greater in both frequency and magnitude than underpriced stocks. In our constant search for new ways to enhance returns for our partners, short selling is one that comes up frequently.
Though it is a common strategy employed by hedge funds, we find the risk/reward profile of short selling to be unsatisfactory on most occasions. Consider a short sale on a stock trading at a price 10x what we believe it to be worth. 10x is a substantial margin of safety, but, even if we are 100% correct, the return amounts to 90% ($900/$1000). Even if the stock goes to zero, gains are capped at 100%. Not by any means a shabby return, but it hardly comes near the returns one might expect from a stock mispriced by such an enormous multiple. On the other hand, a stock need only be undervalued by 50% to offer a potential return equivalent to the maximum of any short position.
The advantages of common stocks – advantages which have made them such a robust asset class – become drawbacks in the case of short-selling, as a short position is the mirror image of a long position. One of the great advantages of owning stocks, indeed part of the reason that they were conceived, was to limit losses of the owner’s investment to 100% while providing no cap to gains. Betting against stocks, on the contrary, involves the possibility of unlimited potential losses with a cap on gains. For the most part, this unattractive risk/reward profile is what, in our opinion, has prevented even the most overvalued of stocks from representing attractive short opportunities.
We think of risk as the probability that an investment will cause its owner to lose purchasing power over the investment’s contemplated holding period. For any investment, our risk analysis revolves around the concept of margin of safety – the difference between price and intrinsic value. This metric tells us how wrong our valuation of a stock can be before we begin to lose money. In the case of longs, a low level of risk means a high level of confidence that our assessed valuation of a business is within the margin of safety. Here, risk can be boiled down to intrinsic value and price at the time of investment.
Once long the stock, changes in the price are only important insofar as they provide opportunities to buy and sell at advantageous prices. If the price declines, owners of the stock may buy more at a discount, and repurchases, which increase each share’s stake in the cash flows of the business, become more effective. Moreover, private equity and strategic buyers are always on the hunt, looking for entire businesses that can be purchased at an attractive price. These buyers typically pay a price closer to intrinsic value and a premium to market value. All of these forces together create upward price pressure, preventing undervalued stocks from staying too cheap for too long. In contrast, overpriced stocks have no such corrective force and, as a result, are more prone to extreme mispricings.
When short an overvalued stock, the leverage on the position can increase without bound, as price becomes unfettered from intrinsic value. Eventually, the short-seller will no longer be able to maintain their position and will be forced to close it out at a loss. In this sense, price fluctuations, which lie outside the control of the investor, can be a source of real risk, as a margin call will turn a temporary loss into a permanent loss. That is, even if your assessment is 100% correct, the position can still result in loss. As John Maynard Keynes put it, “the markets can remain irrational longer than you can remain solvent.”
For the above mentioned reasons, we expect long positions to continue to represent the large majority of our ideas. That isn’t to say we categorically reject short selling opportunities. As with any other investment, we will continue to assess all options on a case by case basis within the context of the rest of our portfolio.