Last year Charlie Munger took much pleasure at castigating Doug Kass as the selected short seller of Berkshire stock.  The utter disdain Munger and probably Buffett had for short sellers was best summed up by Munger’s comments “We don’t like trading agony for money”.  Becky Quick asked Buffet to elaborate on this.

BECKY: I’d like to get your take on them. First of all, on short sellers, he said, ‘We don’t like trading agony for money.’

BUFFETT: The reason he said that is because a stock, when you short it, can theoretically go to infinity. When you buy a stock at 10, you can only lose 10 points. When you short a stock at 10, it can go to 100 or 200. And occasionally you’ll get into a situation on a short where you may know eventually it’s going to turn out to be worth nothing, or very close to it, or it’s a fraud, but what it can do in between can be very, very unpleasant. We like to sleep well, and you can’t sleep well if you’re short a lot of stocks.

Buffet has one explanation for his reluctance to short sell but there are others.  The long term direction of the market is unequivocally higher.  Shorting is swimming upstream in that sense.  None the less, there are plenty of reasons why short selling fits in a portfolio.

None more important than as a hedge against systemic risk.  If the market collapses most stock will go down undoubtedly.  A basket of short selling candidate will hedge a long only portfolio.  Certainly that’s the case but so will derivatives or just a flat out short position in an S&P 500 ETF.  The problem with this strategy is that this kind of portfolio  insurance is expensive, ranging from turning returns into wall flowers to downright catastrophically expensive with put options.

Most managers believe it’s best to get hedged while trying to make money on your shorts.  We are certainly in that camp although from time to time try to hedge our overall portfolio with large amounts of cash and short ETFs.  With that in mind, we are always working on a methodology for short selling candidates.  Some of our thinking is as follows. These are attributes and criteria for short selling candidates.

1. Insider selling near the botton price range. Cluster selling  (insider selling itself is not predictive as insiders sell for a lot of reasons but buy for just one)
2. poor relative strength versus the S&P 500
3.possible declining revenues, operating margins or both.  Best candidates if it is a result of market forces (secular forces beyond the issuer’s control)
4.failure to meet or beat earning expectations on a regular basis
4. Unknown catalyst  (ex loss of a major customer, unfavorable outcome to a law suit, management shakeup,fraud,  etc)
5. Overvalued on DCF analysis
6. Poor Altman Z score or Piotroski’s F-Score
7. Valuation on multiples of revenue and not earnings.  Story and momentum stocks valued on something other than conventional financial analysis.
Important lesson is that you can’t screen on overvalued alone.  Stock can remain overvalued far longer than you can be solvent.