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: