Selling stock shorts can be fun and profitable, but it's a
very risky strategy. Most stocks go up, the cost of being wrong
is huge, even being right might not be profitable, and brokers
charge big fees for you to short. If you're not an experienced
investor who understands all the risks, then you probably
shouldn't be selling short.
1. Swimming upstream
The most obvious, but perhaps most important, challenge in
shorting is that, on average, stocks go up. Not every stock, and
not every year, but the general trend is upwards. According to
data from NYU-Stern Professor Aswath Damodaran, stocks
in the S&P 500 have advanced, on average, 9% annually between
1928 and 2012. Thus, if you choose to short stocks, you're
betting against the odds and history.
2. Being wrong could be your ruin
It's often pointed out that shorting offers a maximum return of
100%, with unlimited potential to lose. In practice, your
potential losses aren't unlimited (your broker wouldn't allow
that), but you could completely wipe out your account. In other
words, if you're wrong, you could lose everything. That's a
pretty big risk, considering it's very possible that you could be
wrong. In investing, nobody is right all the time. Even Warren
Buffett has made mistakes and lost on investments.
Here's a real-life example of how it's really easy to be
wrong. Let's say you were examining a company about a year ago.
The company had generated large losses for five years. Its
strategy was to enter an industry dominated by a few huge
incumbents, which had dominated the industry since World War II
or earlier. The company was developing an entirely new, very
complex product from scratch. The endeavor would require huge
amounts of capital, and the company's ability to raise further
capital was unknown. Finally, the size of its target market was
uncertain. At best, it would cater to a large niche, and at
worst, nobody would want it's products. Its founder and CEO was
talented but also invested in other non-related projects. And
this company had a market capitalization north of $3 billion. A
reasonable analysis might have suggested that this company was a
money-loser, it was on a quixotic mission, and it would never
succeed. In other words, a good short candidate. That's what a
lot of professional, well-informed investors thought at the time
-- short interest on the company was nearly 30%.
If you hadn't already guessed, I'm talking about
, which is up more than 460% over the past year. Elon Musk and
company defied the odds and met or exceeded challenging
milestones, and market sentiment shifted radically. The stock
went on an incredible bull run, perhaps with a few
short squeezes along the way. If you had shorted the stock, you
would've been destroyed. Even though your initial case against
would've been completely reasonable, it didn't work out. You were
wrong, along with a lot of other investors. And, since it was a
short position, your losses would be catastrophic. Obviously,
this is a cherry-picked example, but it illustrates the huge
risks associated with shorting.
3. Being right doesn't guarantee success
Let's consider David Einhorn's battle with Allied Capital. In
2002, Einhorn publicly pointed out accounting irregularities with
the company. Einhorn had a strong case and the bully pulpit.
Allied Capital's stock took an initial dip after he shared his
thesis. But the stock proved resilient, rising over the the next
few years. Along the way, there were numerous tribulations for
Einhorn. Instead of investigating Allied Capital, the SEC
investigated Einhorn. Allegedly, Allied Capital stole Einhorn's
phone records. His wife lost her job at
. Einhorn eventually wrote an entire book on Allied Capital. By
2007, Einhorn was vindicated -- the SEC found fault with Allied
Capital's business practices. Its stock fell below his short
price, but the profits for his fund were small, especially
relative to the time, effort, and aggravation involved.
Of course, Einhorn is a famous hedge fund manager who publicly
shared his case, thus inciting a battle with the company. As an
individual short-seller, you won't experience all the problems he
had. But, it can still be hard. In January, I wrote a
critical article about
. It's a small, Jacksonville, Fla.-based company that has
virtually no business operations. It's been in business for 20
years without ever generating a profit. To keep itself afloat, it
regularly raises equity from new investors, thus diluting
existing investors. The primary beneficiaries of this
non-business are its CEO, Jeffrey Parker, and his cronies in
management. Even as the business loses money and shareholder
value is destroyed, they keep getting paid. At present, the
company's primary reason to exist, aside from lining the pockets
of management, is to litigate patent claims against
. In my opinion, the company's claims are largely hype, and its
only chance to win a claim is legal incompetence (or favoritism).
In August, I reiterated the
case against the company, pointing out its continued cash burn.
In all, there's a very solid case against this company. But that
hasn't stopped the stock from running up. Year to date, the stock
is up 65%. In the end, it's proof that as a
short-seller you're subject to the whims of the market. Even
the worst, most questionable stock might stay flat or even
increase, in spite of common sense and a rational thesis.
4. The costs are very high
Short-selling is expensive. It depends on your broker and the
stock, but there can be borrowing fees. If you use shorts to
increase your gross investments, then you'll pay interest for
using margin. Also, as a short-seller, you're responsible for
paying the dividends associated with any stock you borrow. That
can be expensive.
Last week, a research firm called Hedgeye suggested that
investors short the shares of
Kinder Morgan Energy Partners
. In short, Hedgeye analyst Kevin Kaiser alleged that both
companies were a "house of cards" that under-maintained their
assets and manipulated their financial results. His
recommendation is to actively short both companies without any
specific catalyst that will cause the stocks to fall. Aside from
the fact that his accusations are
complete hogwash, this is a foolish suggestion. Those two
companies pay respective dividends of 4.5% and 6.6%. In other
words, in addition to borrowing fees, margin costs, and trading
commissions, you'll need to pay 4.5% and 6.6% of your investment
annually out of you account to maintain the position.
Foolish bottom line
The best way to generate returns in the stock market is to buy
high quality business at a good price and hold for the long term.
Shorting is challenging and risky, and most investors shouldn't
do it. That's not to say it can't be profitable or useful as a
hedge, but it should be done only by experienced investors who
fully understand the costs and especially the risks. Even
experienced investors should be selective, cautious, and careful
about shorting. It's a tough way to generate returns.
The best investing approach is to choose great companies and
stick with them for the long term. The Motley Fool's free
report " 3 Stocks That Will Help You Retire Rich3 Stocks That
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Brendan Mathews owns shares of Kinder Morgan and is short
shares of ParkerVision. The Motley Fool recommends and owns
shares of Kinder Morgan and Tesla Motors. Try any of our Foolish
newsletter services free for 30 days. We Fools don't all hold the
same opinions, but we all believe that considering a diverse
range of insights makes us better investors. The Motley Fool has
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