Value Investing and Selling Short

Benjamin Graham — and his students such as Warren Buffett and Walter Schloss — generally advise against Short Selling and other forms of Leverage and Margin Trading.

Unlimited Downside

At the outset, It must be noted that just as with Futures — and unlike Stock Purchases and Options — the potential for loss in a Short Selling operation is theoretically unlimited; because there is no telling how much a short-sold stock may rise.

Graham

Benjamin Graham — founder of Value Investing — wrote thus on the subject of Short Selling.

Definition

"A small number of professionals frequently engage in short selling. Here they will sell issues they do not own but borrow through the established mechanism of the stock exchanges. Their object is to benefit from a subsequent decline in the price of these issues, by buying them back at a price lower than they sold them for."
Chapter 1 - Investment versus Speculation: Results to Be Expected by the Intelligent Investor, The Intelligent Investor

Viability

"Selling short a too popular and therefore overvalued issue is apt to be a test not only of one’s courage and stamina but also of the depth of one’s pocketbook. The principle is sound, its successful application is not impossible, but it is distinctly not an easy art to master."
Chapter 1 - Investment versus Speculation: Results to Be Expected by the Intelligent Investor, The Intelligent Investor
"But the fact that Block was able to advance some 35% from that apparently inflated value indicates how wary analysts and investors must be to sell good companies short—either by word or deed—no matter how high the quotation may seem."
Chapter 18 - A Comparison of Eight Pairs of Companies, The Intelligent Investor

Buffett, Schloss and Klarman

Famed Value Investors Warren Buffett, Walter Schloss and Seth Klarman write thus on the subject of Leverage and Margin Trading.

"Our aversion to leverage has dampened our returns over the years. But Charlie and I sleep well. Both of us believe it is insane to risk what you have and need in order to obtain what you don’t need."
"16. Be careful of leverage. It can go against you."
"Just as leverage enhances the return of successful investments, it magnifies the losses from unsuccessful ones. More importantly, nonrecourse (margin) debt raises risk to unacceptable levels because it places one's staying power in jeopardy."
Seth Klarman, Preface (2008): Security Analysis by Benjamin Graham.

Using GrahamValue

By default, GrahamValue's Graham screeners show the most undervalued stocks first. To see the most overvalued stocks first, one simply has to click on the Intrinsic Value(%) column header.

However, to see truly overvalued stocks, one also needs to ignore qualitative ratings; and look at stocks that are not categorized as Defensive, Enterprising or NCAV.

Example - LinkedIn

GrahamValue published in 2012 that — with a P/E of 760 and without strong qualitative ratings — LinkedIn was one of the most overvalued stocks in its database.

However, as Graham predicted, the stock price did not correct itself for nearly 4 years.

Using Options

When considering selling short, it may be a good idea to look at Derivatives such as Options — which have limited downside — with a 5-10 year horizon.

Next: See Graham's notes on selling stocks.