Shorting Bear's Den
by Bill Barker ([email protected])

Before I get started, let me make things even tougher on myself. As you may or may not know, every year right around Halloween certain Fools pick some stocks to write-up as "tricks" or "treats." Last year's tricks went a brilliant four for four, and each stock is now worth virtually nothing. Each "trick" would have been a great stock to short. The year before, the prognostication was nearly as good, with a solid majority of "trick" ideas being phenomenal short picks -- some devastatingly so.

Let me set the hurdle I have to clear a little higher. The Fool Portfolio is laughing to the bank with its short of Mr. Donald J. Trump and his joke of a company, Trump Hotels and Casino Resorts. Shorting obviously can be profitable, and sometimes, as with getting daily laughs at the expense of Ivana and Marla's piggy bank, pretty fun too.

So why am I bearish on shorting? The reason is that although shorting can be successfully employed, for the most part it simply isn't. The vast majority of shorting is simply short-term trading, with little to no appreciation of the inherent lunacy in betting against a good company on the basis that the price is "so high that it has to come down." The price doesn't have to come down, and when you're on the wrong side of that short-term bet, the downside, very much unlike the upside, is unlimited.

Take Iomega <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IOM)") else Response.Write("(NYSE: IOM)") end if %>. Please. (Ba-da-dum!) How many people were just dead right that Iomega wasn't a company to be invested in for the long haul even as far back as the spring of 1996? Plenty. And those who were really, really sure of themselves went out and shorted Iomega back when it rose to what time now reveals was a much too high price (split-adjusted) of $9 a share. Time has proven the bears right. Iomega literally wasn't worth half that amount. But what was the reward for that sound analysis? Iomega managed to punish basically all the short-sellers as it motored up to and beyond $27 a share, and I venture to say a lot of bears covered at a big loss.

Anyone who was shorting Iomega based on sound research and fundamental analysis was crushed -- many losing more than all the money they had ventured. And the short-sellers, from an investing rather than a trading standpoint were, of course, right! But the severe and unsettling pain of being down maybe 300% prevented many from being able to see it out to the now bitter end. Although their analysis might have been better than that of the longs, it turned out they had no choice but to be traders, and losing traders at that.

But, really, how many were shorting in Iomega's case on sound fundamental analysis, and how many were shorting simply on the basis that the price was "just too high"? More of the latter would be my guess, and that is the reason the majority of shorts typically will fail. The majority of short sales are nothing more than guesses about where the price is going to move next, rather than being investments, which seek to gauge where the price has to move, eventually.

For proof of how the market, as a whole, goes about shorting, I took a little look at a randomly selected issue of Barron's which was collecting dust deep in the stacks at the Fool HQ library. Here's a Top Ten List from the March 2, 1998 issue:

WorldCom, Intel, TCI, Nextel, Microsoft, Dell, Oracle, Cisco, Boston Chicken, and Sun Microsystems.

That's not a bad portfolio in my opinion. You've got three Cash-Kings there, and a couple other fantastic companies. Even with Boston Chicken (incidentally one of Merrill Lynch's top ten recommendations for 1998, I kid you not) in there -- that group is up 10% in the six months since February 13, easily topping the return of the Nasdaq or the S&P.

Oh, but actually that's not a portfolio -- it's the group of the largest short positions open on February 13. To a great many people, these were the companies whose price must have "just looked too high."

Is that really investing? That's just betting, right? Put another way -- however these shorts were chosen, it certainly wasn't with much of an eye on the long-term prospects of the business. It was just a pure guess that maybe the market would value these leaders a little more pessimistically in a week or two than it did that day.

That's comical. But it's also the reality of how shorts are picked -- and quite simply it's the antithesis of investing. It's pure trading, and you need look no further than the beginning of that March 2 issue of Barron's to understand the full hurricane-like fury that can befall anybody who picks a short strictly on the basis that "Gee, the price looks too high in the short term." Alan Abelson wrote his piece that week on Amazon.com, referring to "the absurdity of its valuation." Presumably Alan was referring to the absurdity of Amazon's price as being too high for some reason. Anyone who took Alan's blitherings as a call to short Amazon.com probably wishes he'd never bought that copy of Barron's, because the stock has more than doubled since this Wisest of assessments that its valuation was "absurd."

Yeah, there's a place for shorting, but it shouldn't ever be used with any good company that has a price you don't entirely agree with -- even if the price seems "absurd." As Fools have successfully demonstrated, shorting should be done, if at all, only with those companies that are legitimately on their way to zero. But why anyone should spend valuable time digging around in the financials of awful companies, rather than studying great companies with a future, is beyond me.

Next: The Bull Responds