Why Conservative Investors Should Not Short Stocks

Although I generally limit my writing to companies I like and I choose to focus on ways to make money with them, I have occasionally commented on businesses that do not seem likely to be profitable many years from now or companies that have such a high valuation that either a significant fall in stock price is inevitable or it will take many years of growth before the stock price can advance from such a lofty base—with Amazon being a prime example.

Usually, when I mention something like that, I receive the question, “Well, if you don’t like Stock X, why don’t you short it?”

As far as I am concerned, shorting a stock is the exact opposite of dividend investing in a way that benefits get transformed into obligations. For most of 2014, Altria paid out a $0.48 quarterly dividend. If you become a part owner and intend to hold for the long haul, who cares what the price is? There is no urgency for anything to happen—in fact, if you truly understand that wealth gets built when you reinvest at lower prices, you would actually be comfortable with the stock price falling because the reinvested dividends gobble up new shares that will produce higher income, and because the cigarette-maker regularly repurchases its own stock, you actually benefit. And if the price of the stock increases, well, you may enjoy the comfort of knowing that if you decide to sell, you will be able to get more money from it.

The point is this: when you buy an ownership interest outright (which investment jargon calls a “long” position), you don’t need things to happen regarding the stock price. As long as the business grows, you will be rewarded with growing dividends along the way (this is especially true when you are investing in a company that has been raising dividends for 20+ years). And if a business grows at 10% annually, you will get total returns around that mark, provided your starting price was fair.

When you enter the world of short investing, you are introducing time as a crucial element to success. If, for whatever, you decided that Altria was only worth $25 per share and decided to bet against the company—you need that stock price to fall as quickly as possible to ensure your investment return.

Why? Because you have to cover the dividends. For every three months that pass, you’d have to pay out $0.48 each quarter. And worse yet (for someone owning a stock short), you would have to pay the advancing dividend out of your own pocket. Suddenly, you’ve put yourself in the position where are you responsible for $50 on every $1,000 you invest to pay out to shareholders as a tax on waiting for the company to come down to your price, and this “tax” grows with time if Altria continues to increase its dividend.

And then there is the matter of what is called “assess-ability.” Given me thirty seconds before you fall asleep. In the old days, some stocks (like American Express) were assessable and if you were an owner, you were required to occasionally make payments to the company itself if the Board deemed it necessary. S&P 500 companies don’t do that anymore—the worst case scenario is that your stock goes to $0. The consequence is this: the limit of your loss is what you put into the investment.

This limitation disappears when you enter the world of regular stock shorting. If Altria doubles its stock price, you double the amount you owe, without even factoring in the substantial dividend. If it triples in price, so does the amount you owe. And so on. Sure, there is a practical limit (the price of Altria won’t increase one-hundred fold in the next year), but there is no theoretical boundary. The stock you are shorting can always go a dollar higher, and increase your obligation by that amount.

I’m not saying it can’t be done—when you look at the early results of Warren Buffett’s partnership, you will see that he shorted one stock for about every ten to fifteen that he owned outright. On the other hand, he stopped doing that in Berkshire accounts, so maybe he realized that making good money with less risk and emotional hassle is its own reward. As for Munger, I couldn’t find enough details in his early accounts to determine whether he experimented with shorting, but later in his career, he said that he didn’t want to “participate in human misery”, and decided against shorting stocks on principle.

What had the greatest impression on me when I gave shorting stocks a fair chance to see if it made sense philosophically was this: I read about Lawrence Tisch, the legendary value investor and father of James Tisch who runs Loew’s, and how he began shorting the S&P 500 in 1997. He was correct—large American stocks were overvalued—but it wasn’t until 2000 that his prediction proved accurate. Because he was a high-profile investor, he had to endure similar criticism to what Buffett received—“here’s another old man not ready for the internet age.” I wouldn’t want to deal with the psychological headaches of waiting—needing—my theory to come true. “Needing things to happen now” does not strike me as compatible with stock-market investing, and so I choose to avoid it entirely.

Originally posted 2014-11-05 08:00:30.

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2 thoughts on “Why Conservative Investors Should Not Short Stocks

  1. scchan_2009 says:

    Good article. Shorting is not investing. Shorting is speculation, and your potentially losses are infinite. That said, some people make money shorting or in other speculative activities (like George Soros), but I don’t think Soros called himself an investor when he was shorting Thai Baht in 1997 or Japanese Yen last year.

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