Is Shorting an Overvalued Stock a Good Investment Strategy?

by: Benzinga

By Scott Rubin

For the uninitiated, the answer to the title of this article may seem obvious - of course shorting overvalued stocks is a good investment strategy. What other kinds of stocks would you want to short? Certainly not an undervalued stock, right? Since valuation is far from a hard science, maybe we should refine what type of "overvalued" stocks we are talking about.

For the purposes of this article, I am talking about "seemingly" overvalued stocks using all of the traditional valuation metrics - i.e., P/E, PEG, Price/Book, Price/Sales, etc. In order to get an even better define the term "seemingly overvalued," let me provide you with some examples. (NYSE:CRM) trades at a trailing P/E of 245, a forward P/E of 87, a PEG ratio of 4.92, a Price/Book of 14.7, and a Price/Sales ratio of 11.46. Looks to be overvalued, right?

Well, CRM has gained 83% in 2010. Would you want to be short? That wouldn't have worked out too well. How about Acme Packet (NASDAQ:APKT)? This stock trades at a trailing P/E of 97.64, a forward P/E of 53.33, a PEG ratio of 2.40, a Price/Book of 12.19 and a Price/Sales ratio of 17.13. Using normal metrics, this name would appear to be "overvalued." But, the stock has appreciated more than 400% in 2010. It just keeps getting more and more "overvalued."

In fact, many of the best performing stocks in the market today would appear to be wildly overvalued using normal metrics. This includes, Chipotle (NYSE:CMG), Amazon (NASDAQ:AMZN), Riverbed Technology (NASDAQ:RVBD), and F5 Networks (NASDAQ:FFIV), to name a few. These are all stocks that you should have been buying, not shorting. In 2010, stocks with high P/E ratios have trounced their cheaper peers.

While many "value investors" would eschew adding these names to their portfolios in search of more stable, predictable, and inexpensive stocks, should anyone really be shorting these high fliers? It certainly makes sense that not all investors would want to take on the risk of buying shares in these types of companies, but isn't even more risky to short them? I think it is.

Any discussion of this particular topic would be woefully incomplete with out talking about Netflix (NASDAQ:NFLX) and the company's current battle with short sellers. A number of prominent investors, including T2 Partners' Whitney Tilson, have publicly revealed their substantial short positions in this name. When evaluating the stock using normal valuation metrics, it is not hard to see why they decided to bet on a fall in NFLX. The stock trades at a trailing P/E of 69.42, a forward P/E of 47.91, a PEG ratio of 2.28, a Price/Book of 50.45 and a Price/Sales ratio of 4.82.

Unfortunately, for many of the short sellers, their timing has not been very good. Most of them are deeply underwater on their short position as NFLX has surged more than 234% year-to-date. Most, however, are refusing to admit defeat and continue to sit on big unrealized losses. At what point, however, will they acknowledge, as John Maynard Keynes so famously put it, that "the market can stay irrational longer than you can stay solvent."

Tilson, for one, is not giving up. He recently posted an article titled "Why We're Short Netflix" on Seeking Alpha. The piece is an extremely detailed analysis of why, at current levels, Netflix is overvalued and will see a significant fall in its share price over the next year.

In a surprising move, Netflix's founder and CEO Reed Hastings, posted an open letter on Seeking Alpha in response to the arguments Tilson made in his analysis. Essentially, Hastings suggests that Tilson should cover his short position immediately if he doesn't want to lose any more money.

This battle between hedge fund manager and CEO has garnered quite a bit of publicity and will be a story to watch in 2011. Being objective, Tilson is clearly losing at this point, if for no other reason than the fact that he has lost money being short NFLX. That could change, of course. But, I would argue that Tilson's position may be unjustifiably precarious because he may end up being right and still lose a lot of money on this short. The simple logic of such a statement? "The market can stay irrational longer than you can stay solvent."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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