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A Cautionary Tale of Short Selling
From the Mailbag:
Like Marc, I consider myself a contrarian investor. I like to buy when others are selling. Lately, I have noticed that several stocks I'm considering purchasing have high levels of short interest. Do you think the high short interest makes them bad investments? Or is it a sign to buy and take advantage of the inevitable short squeeze?
 I like your style, but I would never buy a stock just because a high percentage of the float is sold short. On the other hand, I wouldn't necessarily avoid it either.
I live by the mantra "Where there's smoke, there's fire." It's important to understand why so many traders are shorting a stock prior to pulling the trigger. But before buying a highly shorted stock, it's important to know how short selling works.
Most of us buy a stock because we expect the share price to go higher. We sell - and hopefully book a gain - once the price reaches our target. Short sellers (more often than not, hedge funds) do the exact opposite. They sell the stock first and then hope to buy it back later at a lower price.
In order to sell short, the trader must first borrow it from someone who owns it. As long as the stock is "shortable," anyone with a margin account can sell short.
Let's say a biotech company, stock symbol ABC, is selling at $100 per share. Jim Q. Shortseller believes its experimental drug doesn't work. In order to make a profit, Jim can obtain a "borrow" on the stock from his broker and then sell 100 shares in his trading account.
Jim is essentially renting the stock.
He will receive $10,000 in his trading account (minus commissions and fees) and his position will show up as "-100." He will also have to pay rent on his borrowed shares in the form of a stock loan fee.
If Jim is right and ABC's price falls to $50, Jim will buy back the 100 shares for a mere $5,000. This is called "covering" a short. He will book a profit of $5,000 minus commissions and fees. Jim is a happy short seller.
But what happens if the stock goes up?
Most short sellers are traders, not investors. This means they typically have a short- to medium-term time horizon for their theses to play out. Most of them are not willing to ride the ups and downs of a stock.
Short sellers have to manage risk, too. So when a trade goes against them, prudent traders will buy back their shares and take the loss.
If ABC stock pops to $130 on good news, most short sellers will run to cover and take the $3,000 hit (plus commissions and fees). The added buying pushes the stock price up even more, resulting in what's often called a short squeeze.
The big question here, though, is why do short sellers do it?
Short sellers are some of the smartest traders I know. They sell short stocks for a variety of reasons. Valuation, accounting high jinks, a new disruptive technology... you name it.
Hedge fund managers spend a lot of time looking for shorts. I know because I was once a portfolio manager and trader for a small "long/short" hedge fund. Sometimes a good short is hard to find, especially when you are mandated to have a certain percentage of short positions in your fund. This is where the "consensus short" comes into play.
I'll give you an example.
Back in 2006, a bunch of hedge funds were short Deckers Outdoor Corporation (NYSE: DECK). Deckers is the company that makes the incredibly popular UGG boots. The stock was trading around $14.
These hedge fund analysts - all men - were convinced that the company's increased UGG inventory meant that the furry boots were just a passing fad. At that point, Deckers was a one-trick UGG pony, and the demise of its flagship brand would have been fatal.
We got a call from one of these Deckers short sellers, bought into the thesis and sold short the stock. I'd like to point out that my hedge fund was based in Florida. We don't wear UGG boots too often here, and it made sense to me.
We should have done our own research.
Our Deckers short didn't work out too well. Deckers traded higher, much higher.
In just two years, the stock was trading at $53 and experienced virtually no pullbacks. The shorts that were not shaken out of their positions got creamed. By that time, the number of shares sold short was so high that the least amount of news would send the stock ripping upward... a short squeeze.
It was a terrible trade for the short sellers, but they weren't entirely wrong. The inventory build was real. The company was stocking up to meet pent-up demand. This is why it is so important to know both sides of the trade. Those who were long the stock knew the "short story." They also knew it was flawed, yet they bought instead.
So the long and the short of it is that I would not steer clear of an investment just because a lot of people are short the stock. Sometimes the shorts are right, sometimes they are wrong.
If the fundamentals check out, go for it. Just make sure you understand the short thesis and the risks involved. Most short sellers are pretty vocal about their positions, so the thesis shouldn't be too hard to find.
Good investing,
Kristin
The Next Presidential Medal of Freedom Winner?
People are buzzing about an inventor who's changing America.
"Few businesspeople have done as much to change the world," says a major economics magazine. The president of a top Texas University called him, "a great man with foresight and generosity."
And now a Pulitzer Prize-winning author is calling for him to win the Presidential Medal of Freedom.
But here's what's really crazy... The invention he created is helping regular people turn every $15 to $20 into "thousands" according to reports. Click here to see how. | |
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