In this clip from the MarketFoolery podcast, Chris Hill, Jeff Fischer, and JP Bennet dip into the Motley Fool mailbag to answer a listener question -- should listener Michael short his own company's stock to hedge for its potentially frothy valuation?
Find out what our analysts have to say -- why it's probably best not to, what investors can do instead to keep themselves from being over-invested in the company they work for, and whom to talk with before shorting any stock.
A full transcript follows the video.
This podcast was recorded on April 14, 2016.
Chris Hill: From Michael in Massachusetts, "A huge pre-emptive congrats on your thousandth episode next week. I've heard every one and I can definitely say you've gotten me safely through three deployments and countless cardio sessions. I've enjoyed your free services so much that I recently became a Supernova member. My dad and I enjoy discussing your recommendations while building our investment portfolios. Thanks for all that you do.
"I did have a quick question. As a new employee of a Fortune 100 company, I've heard that you should not invest additional money into the stock of your own company, since so much of your financial health is already tied in the form of salary and bonuses. Is there any point at which you would condone shorting your company's stock as a hedge, especially if you see the stock as frothy? I know you don't recommend shorting, but I'm still interested in your opinion. P.S., the new Wynn Boston Harbor Casino Hotel in Everett is less than four miles from the city of Boston. Come on, Chris!"
He's right. He is right to call me out, because I got that wrong last week, when Bill Barker and I were talking about that. In my mind, Everett was much further to the northwest of Boston, and in fact, it's just across the harbor. Jeff Fischer, you're someone who actually, on occasion, has been known to recommend shorting a stock.
Jeff Fischer: Yes, JP, too. We short stocks in Motley Fool Pro pretty regularly.
Hill: To Michael's question, shorting your own company's stock?
Hill: Which, when I first read it, one of the first thoughts that went through my head was, "Well, you can't do that if you're an officer of the company; that's illegal." But then I checked with actual lawyers who work here at the company, and they reminded me, no, that's not illegal. But of course, if you're an officer of the company, it does show up on public filings ...
JP Bennett: I love that.
Hill: It would look pretty bad.
JP Bennett: [laughs] Worse than selling, you're shorting your own company.
Hill: [laughs] Right, "The chief operating officer of such-and-such company, in the quarterly filings, "Oh, yeah, I'm shorting 500,000 shares."
Bennett: The CFO shorting shares ...
Hill: Yeah. [laughs]
Fischer: Well, to Michael, thank you. Three deployments, that's outstanding. Thank you for that.
Fischer: Goes without saying, almost. But thank you. As for the question, it smacks a little bit of speculation to me, if you're shorting because the stock looks frothy, because so many stocks look frothy for so long. Whether it's [Amazon.com] or Starbucks, speaking of froth.
Hill: Nice. [laughs]
Fischer: [laughs] I had to get one bad, bad pun in there. So you don't know what the stock is going to do next, of course. And shorting when it runs against you is increasingly painful. When you make a mistake buying a stock, of course, it becomes less painful the more it falls; you're losing less and less. But shorting works the opposite way. The decision to close it gets harder and harder, because it's more and more costly to close it. So I wouldn't short just based on valuation. We short stocks based on a business that we think is in decline or destined to fail, even, or as a hedge, as Michael mentioned, to some other industry or company that we have exposure to.
But something about my outlook on this question is, I wouldn't be comfortable shorting the stock of the company where I worked. Instead, if I had too many shares of it, I'd steadily try to sell that down to an allocation that I'm comfortable with. At the same time, recognize that you can and probably will, if your company is generous enough, own a larger amount of shares in your company than your other holdings. That tends to happen. So if it is a larger part of your portfolio, that can be OK. You know the company very well, and manage it accordingly.
Bennett: Yeah, I was just going to say, this gives me a perfect opportunity to put to use all of the years I spent studying for the CFA. Technically, this has a name. It's called a short sale against the box.
Hill: Against the box?
Bennett: Against the box. It's another name, I'm sure there's a story behind it, no clue where it came from. I know in the '90s, it was a way that was commonly used to hedge out a position and earn the risk-free rate without having to have tax implications. Say you had restricted shares, but you already had a huge percentage of your wealth tied up in that, and you couldn't sell them right away, you could set that up, hedge out that part of the portfolio, then sell that whenever need be. But, I would say, I know there were changes, so you need to consult with a tax expert, because I think there are now tax implications where, if you set this up ... there's another name, I forget what it's called off-hand, but it may be taxed as soon as you set it up, because it's essentially like selling the shares. So you definitely have to consult with a tax expert.
But like Jeff said, doing it just solely based on your gut feeling for the valuation may not be the best call, but you are thinking about it in the right way, in terms of, you now work for this company, you have basically your entire human capital, what you're going to expect to earn going forward, tied up in this company. It makes very little sense to also have a huge chunk of your financial capital tied up in this company as well. You want to try and diversify those two bases. So you're thinking about it in the right way. Maybe speak with a financial planner or tax expert, just to make sure you make the right decision for you. If, for some reason, maybe he got a huge grant, but those are restricted for a while and you can't sell them, so.
Fischer: Yeah. I fail to see the big advantage to shorting, as opposed to just selling down some of your shares. Because when you short, it will just cancel out some of the shares you own. It's kind of a net-net, same thing.