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Shorting Highly Valued Stocks

Hey guys, I wanted to get your opinions on this.  The Facebook IPO made me start thinking of highly valued stocks.  I understand the need for money, since the market can stay irrational longer than you stay solvent.  But couldn’t you run a screen, try to reverse engineer what assumptions are based in valuations depending on how that industry is valued, then try to find very unreasonable stocks.  Seems simple enough in theory, but I was curious what its like in practice.  

Any thoughts?

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You might want to look into a pair trading strategy to limit some of your exposure. There is no guarantee that an undervalued and an overvalued stock will revert to their fair values, but at least they tend to move in tandem. For example, if the overvalued stock gets more expensive the undervalued stock is more likely to do the same, limiting your losses. This takes out the systematic and some industry risk as well.

The downside is that this will reduce your universe or opportunities since, in the Facebook example, you would  need to find a similar undervalued company. I’ve found that it’s easier to start with an undervalued company and pair it with an overvalued company since there seems to be more overvalued companies out there to choose from.

Long LNKD short FB?

Palantir wrote:

Long LNKD short FB?

That’s what I was thinking. How would this work for a company like GRPN though? 

NO EXCUSES

Look not just at high valuation, but momentum plays.  David Einhorn’s made a killing shorting unjustified momentum stocks.  The trick is finding something wrong in the fundamentals.  For example, Einhorn found Green Mtn Coffee was using borderline illegal inventory accounting.  He was right and the stock plummented.  That’s dangerous though since there’s a ton of money following those names.  

Another strategy would be to comb through the 13F filings to see what the largest hedge fund holdings are, find a name or two you don’t like and short them.  If the market takes a dive, hedge funds run for liquidity and are forced to sell their top names regardless of how much they like them so you win that way.  Or, you may just be right about the stock and it takes a dive and when the HFs bail it exasperates the problem and you win bigger.

Bottom line - shorting is fun but not really that rewarding.  You can only make 100% and it’s costly.  Pair trading is less risky but amazingly boring.  

Just remember that the risk is different on the short side. Short squeezes are real, and your position size gets larger as the price moves against you.  

You want a quote?  Haven’t I written enough already???

bchadwick wrote:

Just remember that the risk is different on the short side. Short squeezes are real, and your position size gets larger as the price moves against you.  

I love going long stocks with a big short ratio.  Not arbitrarily, but if I find a stock where 18% of the float is short and I like the fundamentals I’ll dive in.  It’s great when you get that one day 8% pop!

I like the concept of pairs trading. But you need to rebalance the trade, so transactions costs are important here. In some ways it’s like dynamically hedging an option. 

You want a quote?  Haven’t I written enough already???

Sweep has some good points which I mostly agree with.

Highly valued stocks are highly valued for a reason – people want to own them and are willing to pay a lot (over pay). To bet against them, you need to figure out what would cause people to not want to own that stock anymore and then time your short appropriately. Simply shorting expensive stocks is a good way to hit a margin call because the trend usually persists in one direction until there is a sharp correction, and that trend may be anywhere from somewhat to a lot disconnected from fundamentals.

The Street’s game is discounting next quarter’s and next year’s earnings, but the Street as a whole is pretty bad at understanding business models and structural changes in those models or industries that will impact future results. I find it difficult to beat the Street at its own game (my estimate was more accurate by a penny), so I focus on large shifts that will have undeniably negative impacts on the business model, thereby negating one specific quarter’s worth of earnings. You can also short on tough comps with generally slowing momentum.

A few examples:

BEAT – management was lying about business prospects in front of aggressive 3 year guidance numbers. Who guides out that far for a start up business? They got killed by reimbursement. Stock went from $30 to 3.

AMSC – management was lying and committing accounting fraud. After a legacy contract expired, the stock dropped from the low 30s to 3 or less (I closed at 3).

HEV – management lying with unsustainable business model, stock went from 6 to zero.

SODA – tough comps with a fad product (home soda machines? who are you people?)

HOKU – broken business model with dishonest management. Stock went from 6 to zero (such a lay up). Was much higher than that but I didn’t find it in time.

Several others, etc.

I am actually better at going short than going long even though in theory shorting is harder. One of the keys to going short is finding the lie – for it to be overpriced, people have to believe in some “story” that is untrue. If you start with the “claim” and then deconstruct that, you can sometimes figure out that what they are saying is impossible. Usually the numbers will sound very compelling but the overall pitch doesn’t really make sense (HEV – electric batteries made in the US backed by government funding for a product already being made by scale players in Asia for a market that doesn’t really exist yet – how does that even make sense?). After that it is just a question of timing.

The part I disagree with Sweep on is that I think shorting is very worthwhile. In the context of a total portfolio, a well developed short portion of the book provides an incremental source of alpha while providing overall insurance to the portfolio in a sense (in the event of a major market decline).  The reason long / short funds make sense is because you reduce overall exposure and increase performance, assuming you can identify good picks on both sides. Obviously, that’s easier said than done, but if you look at a lot of stocks, some will jump out as shorts – if you wouldn’t even think about looking twice as a long, how is it not at least a decent short candidate worthy of research?

^ How exactly do you find these companies? Do you screen for absurd PE figures?

bromion, any good short ideas at the moment?

Several ways –

1) Analyst upgrades / downgrades. Scan these daily looking for non-valuation related calls and then try to piggy back on whatever the sell side was doing. Bulge bracket firms will often move the stock but reports from smaller brokers may not.

2) Screens

3) IBD top picks – anything overpriced that sounds cheesy

4) Being generally aware of what is going public (often decent shorts within some period of time, say 12 to 24 months)

I think people spend way too much time focusing on a handful of companies. It’s better in my opinion to be generally aware of lots of companies and then be able to laser focus on something that seems out of place or sounds cheesy. Like why is this stock trading for X? This sounds like crap. I already wrote about ZIP, which was an example of that – came up on a scren, I glanced at, WTF is this? Some stupid car company burning tons of cash with an unsustainable model, lying management, slowing growth and increasing competition all while the stock is at a high valuation? Short.

FrankArabia wrote:

bromion, any good short ideas at the moment?

Still short ZIP as I mentioned.

Also short BLDR at around $5 – I think they are going to run out of liquidity and their capital structure is broken.

Also short SQNM around $5. I think management is lying with increasing competition and a cost disadvantage and the valuation doesn’t make sense.

I don’t know if I would initiate a new short on any of those at today’s prices.

Several others on the radar but it’s always a question of timing.

Thanks for all the very interesting information guys!  This is a really good read.

@Bromion, how much time do you think it requires to attempt your strategy in investing?  Do you think you have to be employed in a profession that deals in equities to gain those sorts of insights?

You don’t have to be a professional but it is very time consuming. Having the right intellectual framework helps because a lot of professionals can’t do it even though they spend lots of time. Look at the people who bought facebook and groupon… WHAT WERE THEY THINKING?! lol