a short guide to short selling

Short selling sounds sexy. Uncovering accounting fraud or identifying companies promoting faddish products or services can be exciting. But short selling is often an unprofitable and frustrating activity, best left to institutional investors. Most ‘professional’ short sellers have produced awful results. The $110M AUM Federated Prudent Bear fund is down 75 percent over the last 18 years. The $186M AUM Grizzly short fund is down 90 percent since 2000. And famous New York short seller Jim Chanos’ Kynikos short fund has reportedly turned $1 into a dime since its inception.

The population of dedicated short sellers has steadily declined during my three decades in money management. Most, if not all, delivered disappointing performance, lost assets, and closed shop. Some claim that, despite losing money, they generated ‘alpha’ because their funds declined less than the indexes advanced. This is like bragging about finishing second-to-last in a game of Russian roulette where there are five bullets in a six shooter. You may have lasted longer than the average participant, but you are still dead.

Today, many managers are shorting index funds and ETFs to claim their funds are market neutral. Why do they do this? To justify charging a performance fee without doing the intensive research required to identify and profit from winning short investments. Because the best short ideas almost always have market capitalizations below $200M—and have minimal trading liquidity—asset managers with excessive AUM cannot make meaningful short bets in troubled, often low priced stocks where the risk-reward ratio is on the side of short sellers.

Given the difficulty and risks, individual investors are advised to avoid shorting. But identifying stocks that are likely to decline—possibly to zero—can provide insights into stocks all investors should avoid owning. Simply put, the best stocks to short are the worst stocks to buy. This might seem like a blatantly obvious statement, but folks consistently buy stocks they would be better off shorting and short stocks they’d be better off buying. Here are a few reasons why this happens:

1) A fixation on being “early”

As I have repeatedly warned, buying low-priced (sub-$5 stocks) and/or the stocks of money losing companies are terrible ideas. If a stock is trading in the single digits, that is almost always a clear indication that something is seriously wrong. The vast majority of these low-priced losers never recover—and the small fraction of troubled companies that do manage to turn themselves around are almost always better buys once their stocks cross back into double digits. That momentum shows that the market has begun to taken notice of the recovery, which almost always leads to greater momentum to the upside.

Conversely, formerly high-flying stocks that begin to decline are almost always better shorts once they lose half their peak value or more (preferably a lot more). Shorting a stock before it hits this point on the downside is extremely dangerous, especially when the company in question is still profitable.

One of the few short positions I’ve written about publicly offers a perfect example of the dangers of shorting a company too early. A few years ago, Intuitive Surgical posted a few bad quarters and its stock dropped from the high-$500s into the low-$400 range. As I made clear at the time, I knew Intuitive was (and still is) a great company with smart management, but I believed declining prostrate surgery procedures and slowing sales of its robotic surgery device would bring its still high price-to-earnings multiple down closer to the S&P 500 average. So much for that idea. As anyone who has followed the stock can tell you, growth picked up again and the stock followed suit. This week it crossed $800 for the first time. Luckily, I recognized my error and covered my position long ago.

2) Overvaluing valuation

Value traps are dangerously seductive. Investors get so caught up in book values, low multiples of earnings and other metrics, they forget that the lifeblood of any successful business is growing revenues. Investing in a company with shrinking revenues is always a risky proposition, no matter how “cheap” its other numbers appear. On the other hand, shorting companies with rapidly growing top lines is a good recipe for going broke.

For decades, many short sellers have attempted to “pick a top” in richly valued stocks. This rarely happens. What do Tesla and Netflix have in common? Rich valuations and bottle rocket revenue growth. Yes, their stocks are indisputably expensive, almost ludicrously so. Yes, they may eventually collapse. But as long as they keep growing revenues rapidly, they could both easily double again without ever generating profits or free cash flow. Remember John Maynard Keynes’s legendary quote: “The market can stay irrational longer than you can stay solvent.” Market history is full of overvalued companies that remained stubbornly overvalued long after most shorts busted out or cried uncle and covered.

Shorting a stock on valuation alone is an especially bad idea when it comes to established, profitable companies. When I originally wrote about Intuitive Surgical, its stock was selling below 30x earnings. It currently sells at 43x earnings. Shorting it at less than 30x proved to be a bad idea a few years ago. Shorting it at 43x would almost certainly be an even worse idea now.

3) Undervaluing the perils of debt

The best shorts (and worst longs) are usually companies with shrinking (or no) revenues, relatively large negative cash flow from operations, and often excessive debt. As I’ve written before, if a company has public debt, and that debt has a yield to maturity of 15 percent or more, fixed income investors are already pricing in a high likelihood of bankruptcy. And yet, time and time again, I’ve watched the stocks of companies with high-yielding debt remain elevated for long periods of time, sometimes right up until they officially chapter out.

Many equity investors simply don’t understand the capital structures of publicly traded companies, or how bankruptcy works. Others are so emotionally attached to a company’s story or business model, they want to believe that their low-priced investment will pay off big for them. Whatever the motivation, buying low-priced, heavily indebted companies turns stock investing into the equivalent of buying lottery tickets, with equally long odds.


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