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

Bill has made my job easier by simply agreeing with me. Thanks, Bill. The Fool Portfolio has trumped Trump. The Halloween tricks were more fun than egging a neighbor's house. But even with these great examples before him of how Fools can make good short-sellers, Bill prefers to focus on common shorting mistakes. Well, I couldn't agree with him more. Shorting takes smarts and discipline that lots of investors lack. So don't short a stock until you know how to do it right!

Bill points to two very different problems afflicting bad shorts. First is what I'd call the value-schmalue, or simply "schmaluation" fallacy. Some folks just look at a stock's price/earnings (P/E) or price/book ratio and say, "Man, this sucker's due for a comeuppance."

Yet neither P/E nor any other simple metric is enough to figure out whether a fast-growing company is really overvalued. "Schmalualites" take the "it's just too high" approach without sufficiently evaluating the company behind the stock. But a crappy company selling at 100 times earnings is simply different from a great company selling at the same multiple.

The second problem Bill highlights is nearly the opposite of that experienced by the schmalualite. Short-sellers can often be right about the fundamental analysis and yet still get killed. Iomega certainly offers a great example of this; the book is still out on Amazon.com. This second problem is more troublesome for Fools because it highlights the fact that shorting often does require something of a trader's mentality.

That's because while shorting depends on valuation, valuation is never reason enough to go short. Shorting requires an appreciation for market dynamics, for the risks of a stock moving against you. For example, you may have no trouble finding an overhyped Internet tulip, but before you short, you must evaluate how the float (the number of shares available for trading) and short-term forces (say, more press releases) might affect your position.

Shorting a highflyer is simply more dangerous than shorting a dying company because you must gauge what stage the mania is in, and manias can prove surprisingly crazy. Ideally, you want to find a triggering event (say, an upcoming earnings report) that will slice a stock's price. At the same time, you want to hold back from taking a short position until an obvious positive trigger (say, a new product launch) is out of the way. My only concerns with the Fool Portfolio's Trump position were that I think it should have been taken near the end rather than the beginning of the company's strong summer season. And I think that Da Donald's high profile added a hype wildcard that made it a little riskier than other debt-laden outfits.

Again, the reason shorting differs from going long is that your broker can force you to cover your position when you least want to, either because of a short squeeze or because a stock has moved so much against you that you don't have enough equity left in your account. You can usually sidestep the first problem by avoiding heavily shorted stocks with small floats. You can avoid the second by having a cover discipline (say, buy to cover if the short goes more than 20% to 30% against you) and/or use no more than 10% of your account's equity on any single short position.

Other things to keep in mind... Skeptical journalists such as Alan Abelson can be useful sources for short ideas, but no one should invest long or short based on those writings alone. Journalists don't invest their own money, and valuation alone is never a sufficient reason to go short.

Also, huge companies will always have some of the largest short positions simply because they are huge. Some of them will have outstanding convertible debt offerings that promote shorting due to complex arbitrage arrangements while others will be involved in mergers that also bring out arbitrage shorts. Others will be heavily shorted as part of general hedging strategies. In many cases, these short positions are pretty much direction-neutral plays rather than outright bets the stock will fall.

Those bets are placed on the small companies that make the largest short positions list -- for example, Tel-Save Holdings <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TALK)") else Response.Write("(Nasdaq: TALK)") end if %> -- and stocks with large short interest ratios (shares short/average daily volume), such as Biotime <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BTIM)") else Response.Write("(Nasdaq: BTIM)") end if %> or Chromatics Color Sciences <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CCSI)") else Response.Write("(Nasdaq: CCSI)") end if %>.

Finally, Bill asks why anyone would want to spend time digging through the financials of awful companies rather than studying great ones. Well, some Fools have time to do both. The main reason, though, is that crappy companies receive a whole lot less attention than do the Microsofts of the world. While there may be legions of people that can tell you exactly why Dellis a great company, you may be hard-pressed to find anyone who could tell you why EquiMedwould prove a disaster. That's largely because few people have ever heard of EquiMed. Thoughtful individual investors simply have a genuine edge in shorting that's harder to cultivate in other areas. Because it can be especially rewarding both financially and intellectually, sleuthing for slime is also a lot of fun.

Next: The Bear Responds