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:
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.
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):
Two high profile commodity companies filed for bankruptcy last week. The first was St. Louis-based coal producer Peabody Energy (BTU). Peabody was the latest coal producer to file, following Arch Coal, Alpha Natural Resources, Patriot Coal, and Walter Energy. BTU quickly fell below $1 on the news. Just a few years ago, Peabody’s market capitalization exceeded $20 billion. On Wednesday, Houston offshore oil producer Energy XXI (EXXI) joined Peabody in bankruptcy court. Four years ago, EXXI was a $32 stock. On Thursday, the day after it announced its bankruptcy filing, it closed at 12 cents.
Warren Buffett famously advised investors to “be greedy when others are fearful.” With stocks all over the world getting clubbed in recent days, there is no shortage of fear out there. The question is: will all that negative sentiment become another “wall of worry” that the markets climb to new highs? I can’t say for sure. No one can. I will say that during yesterday’s gruesome selloff, I spent more time adding to my fund’s short book than searching out potential buys. That’s because, even with the Dow and S&P suffering their worst weekly declines in four years, I still see wildly, even stupidly overvalued companies everywhere I look.
As I highlight in the introduction of my book Dead Companies Walking, retired New York money manager David Rocker once wrote that there are three types of shorts: fads, frauds and failures. I generally focus on the latter of the three by seeking out and shorting troubled companies that could soon go broke. Shorting fads, on the other hand, is tricky. Timing is everything, and predicting exactly when a fad fizzles out is almost impossible. Remember “Pogs,” those weird little toy discs that kids briefly went nuts for a while back? It seems unbelievable in retrospect, but two Pog-related companies came public during that mania. Both went bankrupt soon after the craze subsided, but if you’d shorted either of them beforehand, you would have needed some serious intestinal fortitude to stay in the position.
The trickiest fad businesses to short are the ones that grow so popular in such a short time, even seasoned investors become convinced they will turn evergreen. This is particularly true for products that are popular among financial workers and the broader investor class. After all, if the folks buying, selling and analyzing stocks love a company’s products, they’re more likely to overestimate its value and its longevity. As I write in my book, an analyst at a prestigious brokerage once swore to me that there would soon be ten times as many rollerbladers as bicyclists. Before I hung up the phone and shorted the stock of the second largest inline-skate maker at the time, she happily informed me that she and many of her colleagues were avid rollerbladers.
The two biggest “stealth fad” stocks in today’s market could very well be Fitbit (FIT) and Tesla (TSLA). Neither is likely to go the way of Pogs or rollerblades, at least anytime soon. But, like rollerblades, they’ve both benefited from their excessive popularity among the very people buying and analyzing their stocks.
Two weeks ago, I flew to my old stomping grounds in Houston and visited seven energy companies in three days. The mood around town and in corporate offices was far more upbeat than my last few trips down there, and not just because the Rockets were in the midst of pulling off one of the biggest comebacks in NBA playoffs history.
Despite what you might have heard, the oil business is rebounding.
[note: a slightly different version of this post originally appeared on my Yahoo! Finance contributor page]
I’m a sports fan, but I don’t plan on watching the Final Four this weekend. Sure, the players are inspiring and the games are usually exciting and dramatic. I just can’t bring myself to tune in to a bunch of unpaid employees generating billions for one of the most corrupt rackets in the world, the NCAA. But–as regular readers of this blog know all too well by now–my distaste for so-called amateur athletics pales next to the utter disgust I feel for our broader system of higher education.
Talk about an industry desperately in need of disruption.
Last week, I wrote a bearish article on Tesla for Seeking Alpha–not the company, the stock. As I said in the piece (and an earlier blog post), I admire Elon Musk and I think Teslas are neat cars. I’ve even considered buying one. But the company’s stock is another story. The logic of paying more than $200 a share for a barely cash positive business with all sorts of very large challenges ahead of it seems, well, stretched to me. And yet, people keep on buying. The article came out Monday morning, West Coast time. By the end of the day, Tesla was up another eight bucks. A few days later, Tesla beat on its Q2 earnings and the stock started pushing against its all time highs again. Correction? What correction?
Even though I clearly stated in my piece that I have no positions in the company, long or short, and no plans to initiate any positions in the future, several commenters accused me of secretly shorting Tesla and trying to drag its share price down. Unfortunately, this sort of vitriol is common. Short sellers are about as popular as personal injury lawyers and IRS agents these days. In the eyes of most investors, we’re little more than greedy vultures looking to smear good companies so we can profit on their fall. This simplistic, black hat-versus-white hat understanding of the financial world might be comforting, but it’s a dangerous fantasy.
In reality, the people waving the white hats and whipping this bull market higher are the ones investors should really be fearing–or at least questioning.
(Update: I guess I wasn’t done talking about Tesla. I just wrote a longer piece about the company for Seeking Alpha. You can find it here.)
If Warren Buffett is right (and he usually is) that the stock market is a short term popularity contest and a long term weighing machine, you could easily argue that the most popular stock on Wall Street over the last eighteen months has been Tesla (TSLA). Elon Musk’s battery-powered car manufacturer is barely cash flow positive, but bullish investors have lifted it to a market cap of over $25 billion. That’s more than a third of the value of a little mom and pop outfit called Ford Motors.
But this past week hasn’t been kind to Tesla. First, a report from the website The Street called the Audi A8 Diesel a “Tesla Killer.” Besides bashing Tesla’s limited range and likening its interior comfort to a “Burger King” compared to the Audi’s “Buckingham Palace,” the piece also showed that, due to battery depreciation and electricity costs, the Audi is cheaper to own and operate. Then, yesterday, another Tesla caught fire. Of course, your average Honda or Chevy is liable to go up in flames if you plow it into a light pole at 100 MPH, as the driver of the Tesla did in this case. But reports from the scene said the Tesla’s batteries were “popping like fireworks” in the middle of the street. For a car with a well-publicized history of mysterious fires, that’s the last kind of press Musk wants.
Personally, I like Teslas. I think they’re neat looking. I’ve even considered buying one, and I wish Musk the best in his attempts to revolutionize the auto industry. But I am a little weary of the hype surrounding the cars. Sure, they don’t burn gasoline, but they do suck up electricity–and in a lot of places in the United States and abroad, that’s about the dirtiest way you can power a car.