You have heard it before: short selling is risky, short-sellers hurt the economy by publicly attacking companies and profiting from the fall of their prices. But is that really true? What if short-sellers are sophisticated investors, who expose corporate fraud and greed, and do it with well-calculated risks and price targets? A study by the french EDHEC business school shows, that short-sellers are actually good predictors of negative earnings news and analyst downgrades. Another research done by the National Bureau of Economic Research concludes, that firms who battle short-sellers are most of the time trying to hide their fraud and experience a a negative 2% monthly return the next year. Several studies were also done, which show that stocks with the highest short interest actually underperform the most. Based on this and also on my own research, I believe that shorting is a great addition to a stock portfolio in terms of both return and diversification.
I have several rules when it comes to shorting and stick to them because they work for me:
1. Never short a stock that's going up
This rule is the most important one. A bad stock can go up much longer than you can stay solvent. It can be the worst overvalued, crappy, non-competitive or fraudulent business you have ever seen, but as long as people keep buying it, you will get crushed. You can never get the tipping point right, but once the music stops, sentiment shifts and it starts going down there is still plenty of time to short it then. If you believe a 80$ stock is going to 5$, do you think it matters that much if you short it at 60, 50 or 40? Also, you might short a stock on a good price, but wait several months or years for it to go down. Shorting a downtrend is a safer and more prudent approach.
2. Never short a stock just because it's overvalued
Valuation can be very tricky, it all depends on the cash flows and discount rates used. That's why two analysts looking at the same stock can come up with very different conclusions. Furthermore, a good company will always sell at a slight premium because of it's prospects, and can remain at that level for many years. Look for flawed businesses with high competition, unrealistic expectations or accounting tricks in it's financial statements.
3. Never short a stock above it's 150 MA
This rule is simply an indicator to tell you, when a stock stops going up and starts heading down. Stocks below their 150-day MA are a good starting point to look for short candidates. Shorting stocks above their 150 MA will result in too many whipsaws, as it sometimes takes months or even years before a bad stock comes crashing down.
This was a summary of how NOT to short stocks, so let's check now some screening criteria that I use for picking shorts:
1. Price HAS to be below 150 MA:
I never even consider shorting anything above it's 150 MA.
2. Price/Sales > 3
This is a valuation metric, serves better than P/E because it's harder to manipulate and it's more stable. Companies passing this will either be good businesses selling at a premium or bad overvalued businesses with unreasonable expectations.
3. Shares outstanding increasing or staying the same
I look for companies issuing new shares during the year, or avoiding companies that do buybacks. The total number of shares has to stay the same or go up.
4. Short float > 10%
I cannot possibly research every company out there and determine whether it's good or bad. My theory is that when a company has a high short float (percentage of shares sold short out of the total shares outstanding), somebody out there thinks there is something wrong with the stock, so it's worth looking at it.
Companies that I'm currently researching and would fit here are: TRLA, TSLA, DDD, THRX, ATHN, JCOM, IPGP, FIVE, YELP, CNQR and UTHR.
5. Price fall of 15% or more in one day
This one is more like a screener metric, I keep an eye on stocks that experience a huge fall in one day. My research shows that roughly 70% of them are at least 30% lower one year after the fall. These are companies that announce bad quarterly results, statement revisions or negative news. Investors including many analysts usually think this presents a great buying opportunity, but history shows that it's just the first signal of more problems to come. Remember, momentum works on both up and downside. Here are a few examples of such companies: LULU, BLOX, GOGO, TWTR, ARUN, TWGP, ARIA, QLIK, MDSO, IMPV, ANGI, WTW and many more. They might not go bankrupt but they will still fall enough to make a windfall profit.
I have several rules when it comes to shorting and stick to them because they work for me:
1. Never short a stock that's going up
This rule is the most important one. A bad stock can go up much longer than you can stay solvent. It can be the worst overvalued, crappy, non-competitive or fraudulent business you have ever seen, but as long as people keep buying it, you will get crushed. You can never get the tipping point right, but once the music stops, sentiment shifts and it starts going down there is still plenty of time to short it then. If you believe a 80$ stock is going to 5$, do you think it matters that much if you short it at 60, 50 or 40? Also, you might short a stock on a good price, but wait several months or years for it to go down. Shorting a downtrend is a safer and more prudent approach.
2. Never short a stock just because it's overvalued
Valuation can be very tricky, it all depends on the cash flows and discount rates used. That's why two analysts looking at the same stock can come up with very different conclusions. Furthermore, a good company will always sell at a slight premium because of it's prospects, and can remain at that level for many years. Look for flawed businesses with high competition, unrealistic expectations or accounting tricks in it's financial statements.
3. Never short a stock above it's 150 MA
This rule is simply an indicator to tell you, when a stock stops going up and starts heading down. Stocks below their 150-day MA are a good starting point to look for short candidates. Shorting stocks above their 150 MA will result in too many whipsaws, as it sometimes takes months or even years before a bad stock comes crashing down.
This was a summary of how NOT to short stocks, so let's check now some screening criteria that I use for picking shorts:
1. Price HAS to be below 150 MA:
I never even consider shorting anything above it's 150 MA.
2. Price/Sales > 3
This is a valuation metric, serves better than P/E because it's harder to manipulate and it's more stable. Companies passing this will either be good businesses selling at a premium or bad overvalued businesses with unreasonable expectations.
3. Shares outstanding increasing or staying the same
I look for companies issuing new shares during the year, or avoiding companies that do buybacks. The total number of shares has to stay the same or go up.
4. Short float > 10%
I cannot possibly research every company out there and determine whether it's good or bad. My theory is that when a company has a high short float (percentage of shares sold short out of the total shares outstanding), somebody out there thinks there is something wrong with the stock, so it's worth looking at it.
Companies that I'm currently researching and would fit here are: TRLA, TSLA, DDD, THRX, ATHN, JCOM, IPGP, FIVE, YELP, CNQR and UTHR.
5. Price fall of 15% or more in one day
This one is more like a screener metric, I keep an eye on stocks that experience a huge fall in one day. My research shows that roughly 70% of them are at least 30% lower one year after the fall. These are companies that announce bad quarterly results, statement revisions or negative news. Investors including many analysts usually think this presents a great buying opportunity, but history shows that it's just the first signal of more problems to come. Remember, momentum works on both up and downside. Here are a few examples of such companies: LULU, BLOX, GOGO, TWTR, ARUN, TWGP, ARIA, QLIK, MDSO, IMPV, ANGI, WTW and many more. They might not go bankrupt but they will still fall enough to make a windfall profit.
Once I get a list of candidates, I further look into metrics like:
1. Inventory or accounts receivable growth > sales growth
Inventory or AR rising faster than sales is often a bad sign. It means the company might be left over with unsold inventory and later write it off, or it's trying to artificially increase sales by offering customers purchases on credit, which too might later be written off.
2. Operating cash flow lower than net income
This is a so-called "quality of earnings" measure, if the operating cash flow is lower than income, management might be putting some non-recurring non-cash items into net income, trying to pump it up.
3. Free cash flow
I always check if the business generates free cash flow, or if it's capital expenditures are so high, that it needs to invest all earnings just to stay alive each year.
4. Option grants
Excessive option grants create motivation for management to increase risk in the short term and boost performance of the company at the expense of long term success. The best example are the real estate companies and mortgage banks during the years 2003-2006.
It has to be noted, that risk in short selling can be unlimited, because the stock can theoretically rise hundreds or thousands of percent. That's why it's important to always use a stop loss. To summarize, shorting can be very profitable and add to your yearly return, given you do your homework and set the risk properly. I will post my research on some shorts in the following days.
1. Inventory or accounts receivable growth > sales growth
Inventory or AR rising faster than sales is often a bad sign. It means the company might be left over with unsold inventory and later write it off, or it's trying to artificially increase sales by offering customers purchases on credit, which too might later be written off.
2. Operating cash flow lower than net income
This is a so-called "quality of earnings" measure, if the operating cash flow is lower than income, management might be putting some non-recurring non-cash items into net income, trying to pump it up.
3. Free cash flow
I always check if the business generates free cash flow, or if it's capital expenditures are so high, that it needs to invest all earnings just to stay alive each year.
4. Option grants
Excessive option grants create motivation for management to increase risk in the short term and boost performance of the company at the expense of long term success. The best example are the real estate companies and mortgage banks during the years 2003-2006.
It has to be noted, that risk in short selling can be unlimited, because the stock can theoretically rise hundreds or thousands of percent. That's why it's important to always use a stop loss. To summarize, shorting can be very profitable and add to your yearly return, given you do your homework and set the risk properly. I will post my research on some shorts in the following days.
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