Shorting Bull's Pen
by by Louis Corrigan ([email protected])

Short people got no reason to live? If Randy Newman had made that "short-sellers," he would have pretty much summed up most investors' attitude toward folks who try to make money from falling stock prices.

That's because individual investors tend to encounter short-sellers as anonymous online posters who say nasty things about stocks they own. Nobody likes a spoilsport. Novice investors often confuse correlation with causation and blame the "shorts" for a stock's tumble when the shorts may have simply uncovered problems the bulls were too hopeful to notice. The bulls then accuse the shorts of telling lies or of being un-American in betting against a company's stock.

Some short-sellers do come off like arrogant jerks, so it can be easy to dislike them. But even polite, calmly rational shorts get flamed mercilessly. Bulls who get mad at short-sellers, though, are almost always too emotionally wrapped up in their investment to recognize the merits of the bear argument. That's a shame because serious short-sellers tend to be among the best-informed and clearest-thinking investors. They often know a lot more than professional sell-side analysts know or care to admit.

Shorts have to be smart to survive much less to thrive. Think about it. In going "long" a stock, you're aiming to buy low and sell high. When you do this, your risk is fixed at your purchase price whereas your potential return is unlimited. Think Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %>.

A short-seller does the same thing, only in reverse order. She borrows stock from another investor (brokerages make money lending out stock) and sells it hoping to buy it back (or "cover" the short) later when it's cheaper. In simple terms, the short can only make as much as what she sold the stock for: a 100% return -- but she can lose a lot more. Folks who shorted Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> last fall at a split-adjusted $25 have seen the stock rise more than 300% against them -- that is, if they haven't been forced by the dearth of borrowable shares to cover their positions along the way. Ouch!

So short selling is a lot riskier than just buying stock. That's why it's not for folks just learning about investing or people looking for low-risk returns. And it's why only the diligent short-sellers who really do their homework prosper.

But these smart short-sellers actually provide a public service that is distinctly not unAmerican, at least if you consider market capitalism at all American. For example, shorts know how to sniff out garbage accounting and other shenanigans. This serves average investors in a number of ways. First, our economy is stronger if available capital is deployed in the most productive ways. Crappy companies waste capital, so cutting off their supply as soon as possible means there's more available for the good companies that create wealth and jobs.

Second, shorts provide liquidity at both ends of the spectrum. They are sellers when others are buying and, eventually, buyers when others are selling. These dynamics can sometimes promote bubbles, as shorts are forced to "cover" their position in a stock like K-tel <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KTEL)") else Response.Write("(Nasdaq: KTEL)") end if %> that has a small float. More often, though, this liquidity allows buyers to pay less than they otherwise would have and to sell for higher prices than would be possible if shorts didn't have to buy back the shares they had borrowed.

Ethics aside, why should you make short selling part of your arsenal? First, successful investors must become competently versed in the warning signs that shorts look for so they can avoid investing in a bad business. So versed, you'll become adept at spotting those situations where a company's stock has lost touch with the reality of the underlying business. So why not use that knowledge to generate profits rather than just avoid losses?

Second, opportunities abound. Though the "market" over time has risen 11% + per year on average, it's a market of stocks and not a stock market. Even when the Pfizers and Ciscos of the world are kicking butt, you can always find a Boston Chicken <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BOST)") else Response.Write("(Nasdaq: BOST)") end if %>, EquiMed (formerly Nasdaq: EQMD), or EA Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EA)") else Response.Write("(NYSE: EA)") end if %> that's in perilous trouble. Like restaurants, a high percentage of public companies go kaput. Someone's going to profit from their demise, and that someone can be you.

There are many approaches to shorting stocks, including shorting highflying, high P/E stocks supposedly due for a reckoning. Some approaches are needlessly hazardous to your wealth. There's simply no reason ever to short a great company -- a Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>, a Lucent <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LU)") else Response.Write("(NYSE: LU)") end if %>, or even an Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> -- no matter how richly valued they may appear. The safer bet is to look for terminal shorts, businesses that aren't just overvalued by 20% or 30%, but might eventually trade down to zero.

Of course, sometimes virtually any shorting strategy stands a high chance of success. We've been in that kind of environment of late, with the average NYSE stock down over 30% from its 52-week high, the average Nasdaq and small-cap stock hit even harder, and some truly first-rate disasters hidden beneath even these ugly numbers. It's times like these when having 10% to 20% of your portfolio short can prove a pleasant hedge against general mayhem.

Making short selling part of your repertoire, then, won't just make you a better overall investor. It will also increase your opportunities for making money. Sounds Foolish to me.

Next: The Bear Argument