Shorting looked easy in 2008, but in reality it’s a brutally tough business. In many ways, it appearsto involve nothing more than applying the same analyses one uses when determining whether to buya stock: on the long side, investors generally seek companies with good management, strong growth,high margins and returns on capital, little or no debt, clean balance sheets, and sustainablecompetitive advantages all at a low price. Conversely, short sellers look for weak or dishonest management, low or negative growth, margins and returns on capital, high and increasing debt,accounts receivable and inventory, and weak competitive advantages all at a ridiculously high price.But shorting is not simply the opposite of long investing. It’s much harder and more dangerous fora number of reasons:
- Your upside is capped and your downside is unlimited precisely the opposite of long positions. When shorting stocks, you could be right 80% of the time, but the losses from the 20% of the time that you’re wrong could exceed the accumulated profits. Worse yet, a once-a-century storm such as the internet bubble might wipe you out entirely. If there’s even a 1% annual risk of such an event, that tiny risk translates into a 39.5%chance of the freak event occurring over 50 years.
- To prevent such an occurrence, most short sellers use stop loss limits, meaning they will start covering the short if it runs against them a certain amount. This means short sellers not only have to be right about a stock,but also about the timing. If a stock rises significantly, many short sellers will lock in losses, even if they are later proven correct.
- In order to short a stock, you first must get the borrow from your broker, who has the power to call in the stock you’ve borrowed at any time or, worse yet, buy stock to cover for you. Brokers are most likely to do these things if the stock is rising quickly, and they’re probably doing it to other short sellers as well at the same time,so all of this buying pressure can cause a stock to rise even further, triggering even more covering. This vicious cycle is called a “short squeeze” and it isn’t pretty we can show you the scars on our backs.
- Shorting has gotten much more competitive. There are now a few thousand hedge funds (and who knows how many individual investors) looking for the same handful of good shorts, in contrast to a few dozen a couple of decades ago. This results in “crowded” shorts, increasing the odds of a short squeeze.
- A short squeeze can also be created if the “float” the number of shares that trade freely is suddenly reduced.Such a case occurred in October 2008 when Porsche, which owned 35% of Volkswagen, unexpectedly disclosed that it had raised its stake in Volkswagen to 74.1% through the use of derivatives. The German state of LowerSaxony, where Volkswagen is based, owns 20%, so that left a float of only about 5% of VW shares on the market.Three popular hedge fund trades had been to short VW based on weakening car demand, go long Porsche and short out its ownership of VW to “create” only Porsche, or go long VW preferred stock and short the common stock,betting on relative underperformance of the common. In any case, for whatever reason, nearly 13% of all VW common shares were short, so moments after Porsche announced its higher stake, the mother of all short squeezes ensued and the stock instantly quintupled from $200 to over $1,000, momentarily making VW the most valuable company in the world. This was extraordinarily painful for many shorts.
- Short sellers used to earn interest on the cash they held while they were short a stock, but this has all but disappeared due to low interest rates and brokers even charge “negative rebates” on hard-to-borrow stocks,meaning that short sellers have to pay 5%, 10%, 15% or more in annual interest to get the borrow.
- The long-term upward trend of the market works against you (yes, believe it or not, markets used to go up most of the time).
- Gains are taxed at the highest, short-term rate.
- It generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.
- It’s a short-term, high-stress, trading-oriented style of investing that requires constant oversight.
- Mistakes hurt your portfolio more as they compound. If you make a mistake with a long position, it becomes a smaller percentage of your portfolio as it drops. A mistaken short, however, grows larger as it appreciates.
- If you go public with your short thesis, a company can attack you in many ways: file a lawsuit (Fairfax), complain to regulators (who occasionally investigate) (MBIA, Farmer Mac), tap your phone (Allied Capital), etc. Also, expect to get flamed on message boards and in the media. Many people view short selling as evil and un-American