Shorting Stocks: The Truth about this Investing Strategy and When It Makes Most Sense

by Dr. Steve Sjuggerud Wisdom of Wealth Wisdom of Wealth

Shorting Stocks: The Truth About This Investing Strategy and When It Makes Most Sense

by Dr. Steve Sjuggerud, Investment U Advisory Panelist

Thursday, December 5, 2002: Issue #194

Shorting stocks is how you make money from falling stocks - in theory anyway In practice, shorting is one of the most difficult skills to master in the markets.

Today we'll take a quick look at the mechanics of shorting, and then we'll get into how to make it work for you, and decide if it's even appropriate for you.

Buy Low, Sell High Or Sell High, Buy Back Low?

Buy low, sell high. That's how you make money in the markets right? If you buy at $10 and sell at $20, you've got a $10 profit. The thing most people don't know is, you don't have to buy and sell in the traditional order.

Instead of buying first and then selling, you can sell first and then buy. In either case, you've completed a transaction. And if you complete it by buying at a lower price than you sell, then you've got a profit. So if you sell first at $20 and then buy back at $10, you've closed out your position with a $10 profit.

I truly admire the professional short sellers - guys like David Tice of the Prudent Bear Fund, which is up over 100% since the market peak in March of 2000. The fact is short sellers may be the most hated analysts on Wall Street. But they also are often the best.

They don't live the Wall Street life as depicted in movies. These guys spend their days poring over the minute details of accounting statements and government filings, looking for something that doesn't quite add up. And quite often, they'll uncover something, and begin shorting (at say, $20), only to see the price rise (to say $40 which would wipe them out) before whatever they discovered finally comes out in the open and the stock crashes. It's a tough life.

While that sounds rough, financial history is littered with exciting tales of bold shorting sellers such as:

  • The short manipulation on the Erie Railroad by Jay Gould and Jim Fisk in 1868.
  • Or Jesse Livermore, "King of the Bears," making a killing in 1907 shorting Union Pacific railroad the day before the San Francisco earthquake.
  • Or Bernard Baruch's Amalgamated Copper short; also at the turn of the century.
  • Or how about this: the President of Chase shorting his own company before the crash of 1929, closing his position in December of 1929 for a $4 million profit.
  • Or even George Soros, who made a billion dollars in a day shorting the British pound in the late 20th century. I'll recommend some reading at the end of today's e-letter so you can catch up on these stories.

The Reality Of Shorting Stocks Is Much Different Today Than In 2000

At the peak of the bull market in 2000, the concept of shorting stocks for profit was "thought of by the smart circles of Wall Street to be extinct or the province of fools," says short selling expert Kathryn Staley. But short sellers sure look smart now. While most investors saw their net worth cut in half, short sellers saw theirs increase by 50%. Which investor looks foolish now?

Kathryn Staley wrote the book The Art of Short Selling. In it, she breaks down the three types of stocks to look for:

  • You want to be in a position whereby you're shorting stocks/companies in which management lies to investors or obscures events that will affect earnings. (Did someone say Enron? Or WorldCom?)
  • Companies that have tremendously inflated stock valuations are good for short selling. (Amgen, at 13 times sales, would be a good example now.)
  • Companies that will be affected in a significant way by changing external events can be profitable to short. She's talking about events that could make their business obsolete.

Importantly, Staley says, "No mechanical method can capture this universe. And that is what makes short selling lucrative: It takes too much work for most people to fool with it." She's right. It's tough. You can't simply type your criteria into a computer and have it spit out winners.

Stocks Are Still Expensive However, Opportunities Abound For Shorting

So why would an individual investor even bother with shorting stocks? There is a very good reason you'd want to sell short these days - to lower the risk in your portfolio. You see, stocks are still very expensive. By my calculations, all the traditional measures of value (as reported P/E, P/S, and P/BV) suggest that the market STILL needs to fall by 50% to get back to its historical average levels.

While I'm not predicting a market crash, at the very least, I don't expect to see the extraordinary gains we saw in the 1990s. And at worst, yes, stocks could still lose half their value from here. If you had a few short positions in your portfolio - which would rise in value as the market fell - they would balance out your stock holdings, and thereby lowering the risk in your portfolio.

The Truth Is Shorting Stock Is Not for Everyone

Furthermore, shorting is not for all markets. But it makes sense nowadays, while stocks are so expensive.

Amgen, for example, is at 13 times sales. That means if Amgen paid you 100% of sales each year for the next 12 years, you still wouldn't break even. That sure appears to be a very bad investment. Of course, Amgen isn't going to pay you 100% of sales. They've got salaries to pay. Employees to feed. Buildings to keep running.

If Amgen could maintain a 20% profit margin indefinitely (which is unheard of), and sales and profits stayed the same, it would still take you 60 years to break even on your investment if Amgen paid out all its profits to you. Can you see how this is not a good buy? Can you see how chances are much better that the share price might go down than go up? And how, if you were shorting the stock, you might make a substantial profit?

In all actuality, short-term investing is difficult. But for the right investor, at the right time (now, when stocks are expensive), it has a place.

Good investing,

Steve

Today's Investment U Crib Sheet

  • A good way for most people to get exposure to a real short selling professional is to buy the Prudent Bear Fund (BEARX) run by David Tice. You don't have to be the expert. And, as I said early on, this fund goes up when the market goes down.
  • So, we now understand that shorting stocks is not quite as easy as simply placing a sell order with your broker. A lot goes on behind the scenes that you really don't need to know about. However, if you're planning on doing a good amount of short selling, you ought to know the nuts and bolts. A good primer can be found in Investment U issue # 424: Short Selling Stocks: Is It Time?

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