- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Value investing and short selling in volatile markets
Short selling can add significant value to your share portfolio during periods of stock market volatility.
As a value investor in shares you ideally want the market to keep climbing, and prior to the GFC this is pretty much what it did. Within this buy and hold environment, value investors who bought (good) stocks could safely park them in the bottom drawer, knowing that the share price would ride the momentum in an upward trajectory.
However, the post-GFC environment brought with it hitherto unseen bouts of volatility in which the stock market can and does move 1 per cent, even within one week. The wakeup call for value investors is that in an environment where volatility is the ‘new norm’, a buy and hold approach may need to give way to a strategy for actively managing shares.
Balance value investing with short selling
One of the ways you can balance a value investing strategy – based on the worth of the business appreciating – with share market volatility is through what’s called long/short investing. If done successfully, a long/short strategy can add significant value to your share portfolio.
To the uninitiated, the machinations of short selling (aka shorting) involve profiting from share prices going down rather than up. As counterintuitive as it sounds, what you’re doing as a short seller is borrowing a company’s shares from an investment bank or broker and then selling them, with the express purpose of buying them back at a cheaper price, to return to their owner.
While increased volatility and tougher economic headwinds make it harder to achieve adequate returns from long only investment, there is no shortage of opportunities to capitalise on a long/short strategy in some shape or form.
Finding stocks that complement a long/short strategy
Let’s paint a picture of a typical shorting strategy being implemented...
You are sceptical of the outlook for retail due to the negative impact of currency headwinds and rising interest rates on consumers’ appetite for discretionary purchases.
As a result, you identify Myer (MYR) as a stock that will be materially impacted, and on further investigation find that the retailer looks to be fully priced, and as a result may drift lower over time.
Based on the strength of this conclusion, you decide to borrow a parcel of shares from your broker and sell them at $2.59. Over the next six months your hunch starts to play out as suspected, and following weaker employment numbers, plus lower consumer confidence, Myer’s share price drops to $1.78.
At this point you decide to ‘lock in’, buy the parcel of shares back at $1.78 and then return the borrowed shares to the broker. In this instance you have made 81 cents per share (less the agreed borrowing costs).
So what you’ve done is take a bearish outlook for Myer, and marry it with good timing to benefit from the fall in the share price.
Things you need to know before shorting stocks
You’re required to pay interest when shorting a stock, plus dividends if they’re also due. If the price goes up instead of down then you’re seriously out of the money.
So to avoid short-term hype, it’s important to take shorting positions on companies you think will fall in value, rather than rely solely on market sentiment.
Profile of a typical shorting stock
Interestingly, the profile of a stock worth shorting is one that you typically wouldn’t contemplate buying, and many fall into the value trap category. While these stocks appear cheap based on their price to earnings ratio, they have questionable debt levels, fading competitiveness and declining cash flows.
Had they asked the right questions, shareholders in the ill-fated ABC Learning Centres would have seen hefty capital expenditures, minuscule cash flow and growing leverage as compelling reasons to exit the stock up to three years before the company went into administration.
Typical value traps also include stocks overexposed to a single core business that’s becoming a victim of technological change or a shifting regulatory environment.
So while the bulk of your portfolio should be focused on buying companies that appreciate in value, a shorting strategy can add value, especially in today’s highly volatile market. The market is constantly throwing up opportunities to put this strategy to good use.