Steer Clear of Trading on the Short Side

However, it's not worth shorting a company that trades at even 10 times its intrinsic value because management can (and indeed is incentivized to) take certain actions to convert the overvalued stock into a correctly priced one with no decline in price. For starters, they can issue a boatload of stock at the inflated price, which would make the stock price more rational.

For example, let's say a public company has land worth $100 million and no other assets or liabilities. Let's say its market cap is $1 billion (100 million shares outstanding at $10/share). It's trading at 10 times intrinsic value. What a great short candidate! The company then does a secondary offering and issues, say, 500 million shares at $10 each.

Now its assets are:

Cash (from the offering): $5 billion

Land: $100 million

Total assets: $5.1 billion

Market cap: $6 billion

It went from being 10 times overvalued (1,000%) to just 17.6% over intrinsic value. The shorts just got hosed.

Management can also go buy real assets with their inflated currency. This happens frequently, and it did on a grand scale when AOL merged with Time Warner at a ridiculously inflated AOL stock price. The merger has tempered the fall in AOL's stock price mainly because of Time Warner's very real assets. If AOL had remained an independent company, AOL shorts would've done far better.

Another management strategy would be to seek a buyer for the business. The odds are in their favor to end up selling the company at a premium to its already inflated price. Among the 10,000-plus publicly traded companies in the U.S., plenty of hungry CEOs are looking for acquisitions, primarily so they can be knights of even larger castles -- regardless of the price.

Timing Is Everything

Warren Buffett does not short individual stocks. The Oracle of Omaha is on record saying that he and Charlie Munger have never been wrong about companies they thought were great short candidates, but they've almost always been wrong on the timing. Once you short a stock, there's no way to predict when the price will fall. While you're waiting indefinitely, you're also responsible for all of the dividends that the company pays out.

Having some short positions as a hedge is considered acceptable investment philosophy, but I disagree for all the aforementioned reasons. With more than 100,000 publicly traded stocks worldwide, you could hedge virtually any scenario in a long-only unleveraged portfolio with no derivatives. Every business reacts differently to macro factors. Some do well in recessions, while others prosper when the dollar is strong. Still others benefit from rising interest rates. So why not create a portfolio that is likely to weather most storms well and still keep the 8% to 10% house advantage on your side?

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Mohnish Pabrai is the managing partner of Pabrai Investment Funds, an Illinois-based value-centric group of investment funds. At time of publication, Pabrai held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. He appreciates your feedback at [e-mail]. You can access his Web site at www.pabraifunds.com.