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When you sell stock short, you are essentially selling the stock today with the hopes of buying it back at a later date — and a lower price. We know that price follows value; still, management can do a lot to mess with the company's stock price and screw up your short position.

On a short position, your potential gains are fixed and your opportunity for loss is variable. Not a good way to make money. Let's look at a play that could go very bad.

Why You Would Short?

The number one reason to short a stock is because you believe that it is overpriced and you expect the price to drop in the not-too-distant-future. When considering shorting, you need to keep in mind that:

  1. Buffett has never really incorporated shorting in his investment philosophy (he's done alright, no?);
  2. The majority of people owning the stock want it to go up and are buying on that premise; and,
  3. Management can turn an inflated stock price into cash — effectively closing the gap on the difference between price and value and killing your short in the process.

A Simplified Example

If it isn't simple, it usually ain't worth looking at. So, let's look at a simplified case of where a grossly overpriced stock can quickly become fairly priced — without the stock moving.

The Overpriced Company

Let's assume XYZ Company has $1,000,000 in cash, 100,000 shares outstanding, and, well, nothing else. The company isn't operating and nothing is expected to come in or out. The actual value of this company is $1,000,000 — or $10 a share ($1,000,000/100,000 shares).

The Hype

Rumors come out that the company is going to revolutionize its industry. Wall Street goes nuts and runs the stock price up to $50 a share. The reality is that nothing has happened, no money is coming in or out, and the company is still worth $10 a share. A quick call to the company confirms the fact that nothing is happening.

Now Overpriced

As it stands, a $10 company is now selling for $50. If, as we expect, nothing happens at the company, it is still worth just $10 a share and we could effectively sell the stock short at $50, wait for the price to drop to $10, and then buy it back — netting $40 a share in gains.

Lovely, right?

Wrong. Wrong. WRONG!

You know who else sees that $50 stock price? Management — and their mouths are watering. The fact is that overinflated stock prices are assets to the business and liabilities to the shareholders. Let's expand the set-up:

Your friend owns 1,000 shares of XYZ stock — 1% of the company. She believes the hype and has seen her stock price run up from $10 to $50. In her mind, you are nuts believing that the company is overpriced and even crazier for shorting the stock.

The Offering

Management — seeing a $50 stock price — calls their underwriters and investment bankers (the people who run IPOs and sell stock to the public) and explain that they want to have a "secondary" offering of XYZ stock.

The underwriters help XYZ company sell another 300,000 shares at the new price of $50 a share. They sell it to the public by continuing the hype (and bull) that XYZ is revolutionizing the world. After a hefty 7% commission, XYZ company takes in an additional $13.95 million in cash (300,000 shares x $50 a share — $1.05 million in commissions).

The New Value

XYZ now has 400,000 shares outstanding — the 100,000 original shares and 300,000 shares from the secondary offering. It also has $14.95 million in cash on the books — $1 million from before and $13.95 million from the secondary offering.

The new value of XYZ Company: $37.38 a share ($14.95 million / 400,000 shares). Your $40 per share short? Now worth $12 and change — at best.

Buy Low — Don't Sell (Short) High

Selling stock short can be a lucrative play — if you don't get burned by management and the greed of Wall Street's investment bankers. Why add that variable in to your investing? Stick with buying underpriced companies that even management would have a hard time screwing up. Get too cute with your strategies, and you are likely to get burned.

Source: Don't Go Short on Overpriced Companies