Murphy: And your book talks about diving deep into those earnings numbers and isolating the companies that show red flags. What should investors do with that?
Del Vecchio: Our book is not about shorting stocks—which is what I do for a living—but it’s about avoiding a big loss. It’s really applicable to everyone in the market rather than just to those who are looking to short positions as a hedging strategy. The reality is that if you take a big loss, it just takes you that much more in gains to make up for that.
When a 2008 comes along, or a huge market storm comes along, it can have a pretty significant impact on your retirement, and getting back on track is tough. So we are looking to help people avoid a big loss. If you are going to own stocks, you need to pay close attention every quarter to the red flags that show that a business is not doing as well as management wants people to believe it is, or even Wall Street. And you have to be prepared to sell. You can’t be emotionally attached to that position and reluctant to accept that you were wrong.
Murphy: Aside from shorting a stock, what’s the process here that you think investors need to take to heart?
Del Vecchio: We look at combining short-selling with value on the long side. You have to be a value investor and buy $1 worth of assets for 50 cents; there has to be an embedded margin of safety for that value to be realized. Being a growth-stock investor, where you are just paying ridiculous valuations, is very dangerous.
Take the technology sector, for instance, where a lot of people get easily seduced by fancy, glossy stocks. The truth is that the higher the multiple you pay for revenue, the lower your returns are. If you are going to pay big multiples, the more money you lose. We show in our book that combining short protection with value investing on the long side outperforms, even in volatile times, like during the 2007-2009 period.
Murphy: Are we talking about a long/short strategy as the best way to mitigate risk and capture returns?
Del Vecchio: Exactly. Our view is that it has to be long value, and short companies that have fundamental deterioration or aggressive accounting. On the long side, it’s not just picking stocks that have low P/E, but those where there is some catalyst we see for the value to be realized, which is different for each company.
Murphy: Is a growth investor more of a risk taker than a value investor?
Del Vecchio: I don’t know that they take more risks, but the more expectations that are embedded in a stock, the lower the returns, because the smaller the margin for error that management has to work with on delivering those expectations. There’s no company that has seen a smooth trajectory in growth. You can get away with it for years, but eventually you are going to hit that bump in the road. The odds just are not in your favor.
Murphy: As far as bumps in the road, is inflation the next big bump?
Del Vecchio: What really matters is the 20- to 25-year period when you are in your highest earning years, your highest saving years, building your nest egg for your future. That’s really the time frame that holds the key for how well you will do. You could end up in an inflationary period and be down significantly or you could luck out.
Right now, there’s no question in my mind that in the future we are going to see serious amounts of inflation. The government may tell you that that’s not going to happen, but food and energy costs are going up. The Federal Reserve cannot remove the liquidity that they have put out there over all rounds of quantitative easing without triggering inflation. Even if they raise interest rates, reducing the size of the balance sheet won’t be a linear unwinding, so we will have massive amounts of inflation.