SMOD, NOG and my rules of shorting

April 17, 2011

Over the past week, I have liquidated my SMOD position (first described here in January), because tech positions were taking up an uncomfortably high proportion of my portfolio. With my recent addition of DELL and TECD, as well as my previous RSH position, I decided to offload SMOD as it has already run up 25-30% in the 3 months since I’ve bought it, and is close to my target of $8.

In addition, I have also made a change in strategy, deciding to short stocks for the first time in a while. I had previously debated whether to start shorting, and decided that the effort was not worth it, since short positions had to be smaller than long ones, yet the research time used is similar. Since then, the difficulty in locating good value longs has persisted, and I found myself taking increasingly small long positions due to lack of conviction and smaller margins of safety in my latest long ideas. My long positions were becoming almost as small as a short position should be, and at some point, I decided to throw in the towel and just start shorting 10-15% of my portfolio. Although shorting is less valuable to me as a retail investor (I don’t care about hedging the volatility of my portfolio, since I have no clients to please and don’t draw on investment gains for living expenses), I suspect it has become easier to identify potential shorts then longs, and the research on shorts may well help me identify weaknesses in my long positions.

This is not the first time I am shorting stocks. My previous personal experience with shorts is that they underperform longs, but I think that is mainly due to the immaturity of my short strategy at that time. A particularly memorable short was CROX, which sold faddish footwear which management falsely claimed was protected by patents, but was in fact easily replicable. I shorted CROX at $50 a few years ago, covered in a panic at $70, only to see it sink below $10 one year later. I realize that I need a coherent short strategy in order to avoid more instances of the CROX fiasco. After reviewing my past shorts, and re-reading “The Art of Short Selling” by Kathryn F. Staley, I have surmised three rules of shorting:

Rule 1 : Initiate short positions at below 1.5% of portfolio, and cover if they double. My previous short positions were too large, and prone to induce panic when they move against me. Basically, this is my “don’t be lazy” rule. If I want to short, I should do the work and collect the 10-12 names that will comprise 10-15% of my portfolio. And the existence of a pre-determined price at which to cover should also help fend off panic.

Rule 2 : Never short an overvalued stock with competent management. This is my next major class of mistakes. Somehow, good management often seem to miraculously live up to even their overhyped reputations. Or they monetize their overvalued stock by purchasing a hard asset. This is why it is dangerous to short companies like AAPL and NFLX. I will short fads, frauds, and companies with deteriorating industry trends.

Rule 3 : Pay attention to potential acquirers. One of my shorts got acquired at a ridiculous price by a mainstream company. It takes just one idiotic CEO who drinks the Kool aid to completely ruin your short. Don’t short when the company has an underlying asset that is clearly attractive and complementary to larger companies, even if that asset is likely to be fraudulent.

For my first short (in a while), I decided to go with NOG, which was already extensively researched and described at the excellent Bronte Capital blog. I have nothing to add to John’s research, except to say that I started NOG at 1.4% of my portfolio, and will not cover unless it doubles. NOG has a reasonable borrow cost (0.9%), and I am willing to hold it until it trades in the teens.

Disclosure : I have a short position in NOG.

{ 2 comments… read them below or add one }

josh May 12, 2011 at 4:40 am

hi valuegeek,

Why cover a short, as a rule, if it doubles? If it doubles, it becomes twice as expensive thus making it in even better short position. I agree on the small positioning size due to market risk, but covering on a double as a rule of thumb, doesn’t make sense.

valuegeek May 12, 2011 at 8:52 am

Hi Josh,

I agree with your reasoning in principle, but in practice, there are serious dangers with unlimited averaging up/averaging down of your positions. When the stock moves against you, there are two possibilities : 1) the market is getting more irrational, or 2) there is a mistake in the investment thesis and someone out there knows better. In my experience, irrationality can explain small price swings, but when LARGE price movements occur, there is usually a very good fundamental reason. I reevaluate my longs/shorts when they hit 50%/200% of my initial entry point. If after my research, I don’t find a reason why a move of this magnitude has occurred, my assumption is that I am WRONG, despite my not knowing why I am wrong. If I had adopted the policy of averaging down/up my positions if I failed to find contrary evidence to my investment thesis, then I would have sunk a large part of my portfolio into a couple of financial stocks that kept getting cheaper in 2007 for no discernible reason at all, and would have gotten wiped out in 2008/2009.

So basically, sometimes, the market is right, even if the reason is not clear initially. By the time the reasons become clear, it is usually far too late. There must be a mechanism for admitting mistakes and moving on. Loss limits are my mechanism for doing so.

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