Why Shorting Well-Loved Companies At Inflated Prices Is A Losing Near-Term Strategy

 |  Includes: FIO, NFLX
by: Ashraf Eassa

Have you ever looked at a particular stock, saw an incredibly high valuation that seemed completely unsubstantiated, and thought that you may have stumbled upon the short opportunity of the century? Have you also tried to short the stock only to lock in a painful loss? Well, the problem is, at least in the near to medium term, shorting a company that is meeting its targets and executing well solely on a valuation basis isn't likely to work. Just ask David Einhorn about how his short on Chemdex (on which he was ultimately right, but was forced to cover too soon) lost Greenlight Capital 4% of its capital.

Why A Fundamental Change Is Needed

Whenever a company is trading at extreme multiple, it takes a fundamental negative catalyst to bring the stock price down. Why? Well, take Netflix (NASDAQ:NFLX) for example:

NFLX Chart

NFLX data by YCharts

People were more than happy to continue bidding this stock up as long as the "growth story" was intact. Anybody who shorted it at $100, $150 or even $200 was in a world of hurt (and probably got hit with a margin call or two), even if they were ultimately correct in predicting that the stock price was unsustainable in the long term. The crash from $300 to $50 was due to a material fundamental change in the business prospects of the company, and once that happens, people will no longer be willing to pay a significant premium. And the crash is usually violent due in no small part to forced selling to satisfy margin calls.

But until that major catalyst, valuation simply doesn't matter and short sellers will likely be sitting on fairly large losses. People are buying because it's "hot" and they want to "ride the wave" for fear of missing out.

The Trade Is Crowded And You Could Get Squeezed

Another major reason that shorting these seemingly over-valued companies can be incredibly dangerous is that people have already had the "brilliant" idea to short the stock! These "high fliers" very often have very high short interest levels, and even the slightest bit of good news, including the firm seizing market share, beating revenue/earnings estimates, raising outlook, acquisition rumor, and so forth, will cause a major squeeze and significantly burn the short sellers. As a prime example, I cite Fusion-io (NYSE:FIO):

FIO Chart

FIO data by YCharts

By all valuation metrics, this company is significantly overvalued. It's trading at 7.2x sales for a staggering $2.6B market cap, while managing to lose money, despite strong gross margins in the 50%+ range. Of course the flash storage segment is hot, and Fusion-io has very interesting proprietary technology that competitors haven't quite been able to match, which fuels the argument that the firm will grow into its valuation. Further, the firm is well known for having a number of high profile clients such as Apple (NASDAQ:AAPL), Facebook (NASDAQ:FB), and Cisco (NASDAQ:CSCO), further fueling the sales growth story along with the occasional acquisition rumor.

It seemed that the shorts were finally "right" from about April to July until a strong earnings report (meaning the firm didn't miss analysts' expectations) coupled with good guidance for the next fiscal year caused a massive short squeeze. Why?

Well, it seems that short sellers (about 25% short interest) are incredibly stubborn and refused to cover during the dip and consequently were "squeezed" by the report, even if nothing fundamental about the absurdly high valuation had changed.

So, How Do I Short More Safely?

The best way for most people to short isn't with common stock, as the downside is theoretically unlimited. I suggest instead buying far dated "put" options. This allows the investor to have a very clearly defined downside. Further, the additional time allows the investor to be "right" in the long term even if he/she is "wrong" in the near-term.

Another strategy is to short the common stock and then protect it with fairly long dated call options. However, the problem with this strategy is that "high fliers" are usually broadly expected to keep "flying high," so these call options are usually a pretty expensive hedge.

Finally, if one does not want to use options and simply wants to short the stock, it is advisable to wait for a negative catalyst and then "get in." Further, don't get too greedy; cover when you've made a good amount, because these stocks often can see violent rebounds from whatever negative catalyst brought them down in the first place (see the Fusion-io example above). Also, if you short the stock and your bet starts to lose, make sure to have a clearly defined "maximum pain" threshold at which you will get out. While stop losses (mentally or actually entered in with your broker) do not protect you from gaps-up due to acquisitions, extremely good news, etc., they are useful risk management tools when shorting since there's no guarantee that a company will ever "come back down" from a 50% gain.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.