short selling as an investing tool (I)

Yesterday I argued that there’s a long-term tendency for the stock market (in any country outside Japan) to rise.  There are two reasons:

–national monetary policies are set up to avoid deflation by encouraging mild inflation, so nominal prices generally rise; and

–at least some people aspire to economic gain, or to creating new products and services, so in the absence of government policies that discourage these activities, real GDP also tends to rise.

Where does this leave short selling?

As it turns out, my first portfolio job–after four years as an analyst–was (luckily for me) working for an extremely skilled investor on a short portfolio.  So I know a little about the subject.

I’m going to write about this topic in two posts.  Today’s will cover the basics.  Tomorrow’s will be about hedging techniques used to control the substantial risks that shortsellers take on.

why professionals find shorting attractive

Two factors make short selling theoretically attractive, even in a world where stock prices generally rise:

creative destruction:  Often, the rise of a new product or service sounds the death knell for an older competitor who is unwilling or unable to adjust.  Specialty retailers began to replace department stores in the move to the suburbs thirty-five years ago.  They are being supplanted now by on-line commerce, as well as by the reemergence of more flexible generalists like WMT and TGT.

less competition:  Most professional investors gravitate toward the long side and toward fast-growing new industries.  As a result, there may be four or five sharp minds looking at every long idea for every one looking at a short.

why it’s not for everyone

1.  I think shorting is harder than buying a stock you think will go up.  The long side has many types of specialized investors.  For instance, there are large cap and small cap specialists, value investors and growth investors, special situation investors.  For a stock to rise, one of these groups has to like it.

But for a short idea to go down, everyone has to dislike it.  Not only do you have to have a certain quirky turn of mind (a kind of Schadenfreude) to be a successful shortseller.  You also have to be able to put yourself in the place of groups with different parameters for what makes a good stock and think out why your potential short won’t interest any of them.

2.  It’s riskier to short stock than to be a buyer.  When you short a stock, you borrow shares from someone else and sell them.  You  hope you can buy them back later on at a lower price, so that you can return them to the original owner and close out your position.

In the meantime, you have to post collateral, which is held by a third party.  The amount of the collateral needed to support the short position goes up if the price of the stock you’ve shorted rises–sort of like margin debt in reverse.  Two implications:

–you can be absolutely correct, but being early, with an insight that runs counter to the mass mind of the market, can be a killer.  Suppose, for example, you thought MSFT’s best days were behind it at $35 a share in early 1999 and shorted it then.  You would have been right on a two-year view.  But in the intervening time the internet craze drove the stock up to close to $60.

It would have been an even more testing experience if you thought PMC Sierra (PMCS–now a $8- stock) was over valued at $50 in late 1999.  Again, you would have been right on a longer-term view.  But that stock, smaller and zippier than MSFT, flirted with $250 a share both in early and in late 2000.

Yes, PMCS and other internet-related chipmakers were unusual cases.  But the fact remains that in any short you run the risk of running out of collateral and having to cover your position at a substantial loss before the world realizes you’re right.

–a related risk, though more of a worry for professional shortsellers than for you and me.  Your broker can change his mind about your creditworthiness and increase the amount or type of collateral he requires.

That’s it for today.  Hedged vs. unhedged shorting tomorrow.



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