Many investors have a wealth of knowledge about making investment decisions. However, I find that most investors consider long-only alternatives. That is, they do not consider short-selling.
Short-selling can work out pretty well for savvy investors. Short-selling not only can hedge the market value of a portfolio during a downtrend, but also it can provide a different source of alpha. There are plenty reasons why investors should consider short-selling. This article focuses on those reasons, and the strategies that make short-selling a profitable venture.
Short-selling allows an investor to profit from negative views about a company, but negative views should be well considered
It is crucial to recognize that the short-selling approach is very much like a long approach. When shorting, an investor must have a researched thesis to back the reasons a company will lose business. Short-sellers should focus on stocks whose underlying business is going to lose economic value. For example, a company loses economic value either when it has an obsolete business model (think RadioShack (NYSE:RSH)) or by a combination of excessive leverage and incompetent management.
Note that having a real negative view about a stock is not the same as seeing a stock as overvalued. Investors should avoid short-selling a stock simply because it is overvalued. Why is that? It's very simple.
The market can remain irrational much longer than a person can remain solvent. Often times, companies are overvalued for a reason. Fundamentally good stocks tend to be priced fairly, and when they are covered by many sell-side analysts, they tend to carry high multiples, which means overpriced.
Shorting companies that are just overvalued is essentially timing the peak of a company because the market is always forward looking. For that reason, a stock overpriced for a long is not necessarily an immediate short. In order to profit from short-selling in the long run, investors must find businesses that have fundamental and critical problems.
Image source: Binary Moon
There are more market inefficiencies available when considering short-selling, for a number of reasons
First of all, sell-side analysts typically have positive views, which lead to buy recommendations. Since sell-side is very influential among both institutional and individual investors, their recommendations are widely followed. As a result, there is an overwhelming amount of long recommendations. On the short side, not so much. For that specific reason, Seeking Alpha offers one of the largest libraries of short ideas out there.
Second, short-selling is altogether avoided by retail investors who aren't looking for stocks to short, such as dividend investors. Shorting a stock has no dividends benefit. Also, the ability to know which stocks to short is a matter of skill, which sometimes is not a priority for traditional buy-and-hold investors. For that reason, the chances of the stock market having an overvaluation bias are higher than having an undervaluation bias.
Third, value investors tend to look for fundamentally solid companies that happened to be undervalued. However, few value investors are on the lookout for poor companies or value traps. In fact, the name "value trap" implies a stock that isn't really worth anything. It's just a trap. Value investors want to avoid value traps. For that reason, value traps tend to be good short candidates.
The idea of a turnaround may attract value investors. But the idea of a company shrinking only attracts short-sellers. In fact, in every value investment, there is a growth component somewhere. The very meaning of "value investing" stands for investing in stocks that are going to grow in value, and not stocks that are going to shrink in value.
For those reasons, the herd typically goes long. The herd sells stocks it already owns. By short-selling, investors reduce their chances of following the herd. In a way, short-selling is not only anticipating the herd, but also it is a way to be contrarian.
Short-selling allows investors to profit from a company's deceptive accounting or fraud
The standard expectation is that management will honestly report earnings, assets and cash flows. But many times that is not the case. While regulation has tirelessly worked to improve accounting standards, there will always be a way to game the system. It has happened time and time again.
By short-selling, investors can profit from these scenarios. Therefore, investors gain exposure to a different economic force. The force of fraud and deception. The trick is, how hard are you looking for them? Can you catch them?
In The Big Short, the famous book and movie, Michael Burry was able to find deception by reading countless pages of bond indentures. Prior to his recognized move against mortgage bonds, he read thousands of pages to find out the entire subprime lending was a time bomb against investors.
Short-selling should be a company-specific, bottom-up approach
Short-selling is best exploited when investors find a company will lose value. For that reason, it is better to rely on bottom-up analysis for short ideas. Top-down approach can be used to analyze macroeconomic and industry specific data, but the investment thesis is best derived using bottom up. Short-selling is best executed when investors have strong confidence that a company will lose value.
Vehicles for short-selling
The most common way of selling short is by borrowing the securities from your broker. However, the options market also allows investors to take "short-like" positions without needing to borrow securities: By purchasing a put option, investors will benefit from a decline in the stock price.
It takes time and effort to build a short case. Seeking Alpha is a true filter to find short ideas that are worth exploring further. Investors should know that in order to successfully short a stock, a lot of homework must be done.
Short-selling provides investors with a source of return from different economic forces. By considering a short position, and employing a disciplined approach, investors can greatly benefit their long-term returns.
Always remember that just because a company is not good enough for a long investment, that doesn't necessarily make it a good short.
Disclosure: I/we 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.