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The Bullish Case for Short Selling



October 04, 2010 – Comments (4) | RELATED TICKERS: MSFT , CSCO , XOM

It is taken as a given that if you are short selling, you must bearish. This is does not need to be the case. In fact, shorting stock can be one of the most bullish activities you can engage in.

No, I'm not on crazy pills. Let me explain...

Right now I look at the S&P 500 as a whole as being cheap. Not just cheap, but very cheap indeed. As the Fool has reported countless times, corporate profits now exceed pre-recession levels. The top-heavy index is dominated by high quality businesses (such as Exxon and Microsoft) that trade near 10x free cash flow. It seems highly likely that the S&P will perform well over the next 10 years or so.

But there is a flip-side to this bullishness that is often forgotten: If I expect returns for the index as a whole to be excellent, then it stands to reason that beating the index simply on the long side may prove difficult. During a strong bull market, such the one in the 1990's, the index made prudent long managers look foolish (and not in a good way). It was in the eventual bear market that active long managers (such as Bruce Berkowitz at Fairholme) made a strong case for themselves.

In fact, from 2000-2010 value investors such as Fairholme made incredible profits on the long-side...during an extremely bearish decade. The bear decade was the perfect backdrop for demonstrating a value investor’s skill. They could use their skill to add value because the index itself was so terribly constituted (think of Cisco's year 2000 dominance of the S&P 500 at 130x earnings).

Now, here's the kicker: If the index today is as wonderful a portfolio as I think it is, then it stands to reason that  finding stocks that will under-perform it should be a realistic task. (Index leadership is often narrow. In 1999, for example, most the performance was led by small group of stocks.)   Earning alpha on the short-side should be a fruitful enterprise when the index is such a hard bogie to outperform. All you need to do is buy an index ETF, short a stock that will under-perform the index, and then profit.  Bull markets are also volatile, so having gains on the short side can provide additional ammo (buying power) during the inevitable corrections. If the shorted stock doesn’t simply underperform, but actually goes down in value, then additional performance is added that otherwise wouldn’t be there.

If you plan on hedging any shorts with long index ETF (as the Motley Fool advises)  - then adding value through shorting should be easier, not harder, during a bull market.  As for me, I’m going to start adding underperform picks to my CAPS account.

4 Comments – Post Your Own

#1) On October 04, 2010 at 8:52 AM, ikkyu2 (98.18) wrote:

If going long the index is such a wonderful proposition on its own, why are you so bound and determined to find a strategy (yours requires margin, so you are a bit disingenuous when you say just allocate 1/2 to the ETF and half to a short) to outperform it?

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#2) On October 04, 2010 at 1:14 PM, MegaEurope (< 20) wrote:

I don't disagree with being long-short. But what if you're wrong, the fundamentals are not as great as you think, and we are entering a more bearish phase the next few years? Then you will be making a mistake by buying the index instead of bottom-up value investing (which you note should outperform the index in bear markets.)

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#3) On October 05, 2010 at 12:56 AM, cbaines2 (98.65) wrote:

@MegaEurope: Of course you could always use a low-cost value fund on the long-side instead. No objection there. I'm a fan of Longleaf Partners personally.


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#4) On October 05, 2010 at 1:28 AM, cbaines2 (98.65) wrote:

@ikkyu2: I like your question. I assume people come to the Motley Fool looking to "beat" the market and not just match it. Having said that I have nothing against index investing, which is a successful strategy that I often recommend. 

I don't imagine Fools shorting just for the sake of shorting. If you can't see any short opportunities out there, then by all means don't short. But at the same time a good opportunity is a good opportunity, and if it just so happens to be on the short-side of life I wouldn't discriminate against it. Afterall, I'm guessing the short will be made in the context of a long portfolio where it is naturally hedged in part. 

The traditional acedemic reason for shorting I haven't brought up, and that is of course to minimize the volatility of a long portfolio. I find this reason less than compelling, however, simply because I try to differentiate between volatility and risk. Making the occasional short will, however, temporarily reduce the volatility of a long portfolio while any shorts are active.



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