To short or not to short

In a recent blog posting, John Hempton complains about the slim pickings in small cap value stocks, and relatively cheap large cap stocks. He finds more trash than gems among small caps nowadays, and as a result, Bronte Capital is now running a long large cap short diversified small cap portfolio. I, of course, am not running a hedge fund. I am an amateur investor who runs my own money for fun and profit. I’ve worked out a long time ago that if with only several hours a week to devote to stock analysis, the strategy with the highest long-term return is to concentrate on long-term holdings of small cap stocks. The only caveat is to ensure that you’ll never have to liquidate them under duress. In times of stress, small caps get absolutely crushed, a fact that any small cap investor who has lived through 2009 can attest to. But I held onto nearly all my stocks, and made it through that period unscathed. You just need to choose your small cap properly and always have a safety margin in mind.

But recently, I have also noticed that it is becoming incredibly difficult to find additional small cap value stocks, so much so that I have difficulty assembling a portfolio consisting of just 20 such stocks. As a result, I have started to put some large cap stocks in my portfolio as well. But I am uneasy with this strategy, because large cap stocks usually underperform small caps, especially over long periods of time. It takes a lot to move the needle with large caps, and even if they move, the price appreciation is usually very modest.

I have also started thinking about shorting stocks. I have done some sporadic shorting in the past with a modest return, but in general, my long positions vastly outperform my short positions. One major problem is that when shorts move against you, the position size increases, and so initial position sizes with shorts must be much smaller than for longs. This means that I have to do a LOT of research just to put a tiny portion of cash to work in shorting. Secondly, you can technically be forced to cover a short at any time, since you have only borrowed the stock and do not own any rights. While I have never been forced by my brokerage to cover a short position (nor have I even heard of anybody being forced to do so), the possibility nevertheless hangs like a Sword of Damocles over any short position. Because of these reasons, I have already decided that if I were to engage in shorting, I would do so not on the basis of an analysis of the fundamentals, but by collecting a list of suspected fraudulent and/or overvalued stocks and shorting the entire basket. This strategy requires minimal time on analysis, and limits damage which short squeezes and forced covering can cause. If any of my readers think that this is a good or bad idea, I’ll appreciate any feedback.