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:
The “Trump Bump” will soon come to an end, and earnings will once again drive stocks higher or lower. Bulls think 2017 S&P operating earnings could hit $130 per share. Who knows if this happens? Even in times of relative stability, it’s foolish to predict the markets—and probably the only thing everyone can agree on these days is that our current situation is far from stable. There are too many variables, including uncertainties about the policies President-elect Trump will put forward, to have any clue where the market will wind up at year’s end. Will Trump succeed in cutting the corporate tax rate or start a crippling trade war with China? Will he “repeal and replace” the Affordable Care Act or throw the whole healthcare sector into chaos? Your guess is as good as mine, and anybody who claims to know is probably a partisan hack or a salesperson, or both.
One thing we can be sure of is that, as always, a handful of big movers will disproportionately impact the indexes in 2017. Last year Nvidia was that stock. I wish I knew what this year’s breakout name will be, but all I can offer with some certainty is that even if the indexes post another year of low double-digit increases, more stocks will struggle than flourish. Quite a few businesses could vanish altogether. Avoiding these laggards and soon-to-be zeroes is just as important to investing success as scouting for potential five or ten baggers. And one of the best ways to do so is to identify larger secular trends.
Stock picking is hard. Most institutional and retail stock pickers underperform the indexes. But every investor could improve the likelihood they beat the market by following one rule:
Avoid high profile, controversial companies where an adverse news event could produce an overnight price collapse.
Three stocks have proven the utility of this investing rule in spades: Valeant Pharma, Wells Fargo, and Mylan Labs. All three have been scrutinized for behavior labeled unethical by some and illegal by others, and all three have cost their investors in a big way because of it.
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Two of the roughest, most failure-prone sectors in the stock market have always been—and probably always will be—restaurants and retail. Competition is brutal in both spaces, margins are usually slender, and bankruptcy always seems to be one poor management decision away.
I’ve written about the slow-motion train wreck of the traditional retail sector fairly regularly over the last couple of years, and with several large operators like Nordstrom’s and Kohl’s posting surprisingly decent earnings lately, I thought it might be a good time to check back again. Could brick-and-mortar retail be on the brink a comeback?
One of my favorite investing quotes comes from the legendary 1968 book The Money Game by George Goodman, aka Adam Smith: “If you do not know who you are, Wall Street is an expensive place to find out.”
I put this line at the beginning of my book because I’ve seen its wisdom proved again and again in my thirty-plus year career. As ironic as it sounds, the folks who start out in the investment business just to make money usually make less of it. The ones who do so because they’re inspired to learn as much as they can tend to make more. Of course, there’s nothing wrong with wanting to make money. We’re all trying to do that—the more the better. But if investing doesn’t fuel your intellectual curiosity, you’re probably not going to make as much money as you hope, and there’s a good chance you’ll go broke.
Wall Street has always been captivated by controversial companies, controversial leaders, and controversial mergers. Tesla’s shocking offer to buy SolarCity on Tuesday featured all three, so it was no surprise that the deal instantly seemed like a bigger story than the presidential race, gun control, ISIS, and Brexit. It even managed to make the last controversial company that dominated headlines, Valeant Pharma, seem like an afterthought.
A few people have written in asking my opinion of the deal. The short answer is, I believe investors are well advised to avoid both stocks like the plague. As separate entities, these companies are wildly overvalued story stocks with a good chance of going broke. Together, they will form one wildly overvalued story stock with a good chance of going broke.
I’m traveling this week, so I’m not able to write a new blog post, but I thought I would share the video of the presentation J. Carlo Cannell and I made at last year’s Stansberry Conference in Las Vegas. (Email subscribers can find the video on Youtube by clicking here.) I’m scheduled to present at the conference again this September. You can register here if you’d like to attend.
As last year’s holiday season was kicking off, I cautioned investors for the second year in a row to beware of the traditional retail sector. Since then, things have gone from bad to worse. This earnings season has been an unmitigated disaster, with one retailer after another turning in disappointing reports. Gap, Nordstrom, Macy’s, JC Penney, Kohls, and others have all dropped precipitously.
Some contrarian investors who buy out of favor stocks in out of favor industries have started calling a bottom for these companies, positing that the recent selloff provides an attractive entry price for long term investors.
This is part two of my responses to some of the emails, messages, and tweets I’ve received in recent weeks. Part one was posted on Monday.
A number have readers have contacted me wondering about specific stocks. I generally don’t like to comment on companies I haven’t studied, so I have been reluctant to offer my thoughts on most of them. However, I thought it might be worthwhile to respond to this tweet from Thomas Yarbrough (@tmyrbrgh):
Once again, I’d like to thank everyone who has emailed, messaged, or tweeted at me since my book Dead Companies Walking came out. I’ve tried to reply directly to as many folks as possible but running my fund has taken up most of my time and attention, so I thought I would post my responses to a few interesting questions, comments, and criticisms I’ve received in recent weeks here. Unfortunately, I couldn’t fit everything into one post, so I had to break my responses up into two parts. I’ll post the second half on Wednesday.
First up, an email from a reader named Greg:
“I am a private investor who has been investing on the long side for most of my career. I’ve almost finished your excellent book, ‘Dead Companies Walking,’ and it has inspired me to start trading the short side as well. My immediate question is: Where do you find all the good ideas? It’s fairly easy to find long ideas in places like Value Investor’s Club (of which I am a member), or the published portfolio lists of hedge fund managers. But where do you get quality short ideas? Thanks for your help with this!”