- If you ever happen to short growth stocks, be very strict about your stop-loss limit.
- Many factors came together in 2020 that moved Tesla's stock substantially.
- I still remain bearish, but advise against initiating a short position in Tesla.
As an investor, you are permanently exposed to the danger of losing your invested money. Selling stocks short brings new challenges in the form of potentially losing more than you invested. Even if your short idea turns out to be correct in the long term, you are vulnerable to bleeding out before your trade proves you right. Shorting stocks is thus dangerous since it requires you to time as well as to pick correctly. That asymmetric risk must not be underestimated prior to initiating a short position.
As an extreme cautious tale about short-selling, take for example the case of Wirecard AG (OTC:WRCDF, OTCPK:WCAGY) from Germany. A very reputable newspaper, the Financial Times, made serious fraud allegations about Wirecard as early as 2015. The company went bankrupt only in June 2020 after in the meantime rising four-fold and reaching its peak in summer 2018. The initial allegations by the Financial Times all turned out to be spot on.
That was an extreme case of fraudulent conduct which only relates to the main topic today in pointing out the dangers of selling stocks short.
I have lost a lot of my own money shorting Tesla (TSLA) stock last year in the midst of its strongest bull run. The fact that not all of it is yet realized does not make it better. The silver lining is that I am much richer in life and investing experience, even though nothing I learned, was completely new to me. It is just that when you learn something while feeling intense emotions, the material sticks in your brain a lot better. Let me share my experience with you, so hopefully, you can benefit from my experience.
I took a short position in Tesla last year before the stock split was announced. After it rose, I doubled my position. After the stock climbed steadily and in bursts of sudden upward moves, I hesitated to close out the position and the situation got worse after each latest news catalyst. On top of that, the macro-economic circumstances tied to the global pandemic propelled growth stocks and some particular industries, like electric vehicle, biotech, and technology. In the case of Tesla's magnificent bull run last year, many influencing factors played in favour of Tesla and against its short sellers.
Allow me to list the lessons I have learned the hard way in the hope you might avoid them and be more prudent.
Short-term trading positions are left in the portfolio to reach break-even
You initiate a short-term trade because you think you know what is going to happen next. The trade moves against you and you then hesitate to close because you think that in the coming days/weeks it will go back to where you expected it. The market will come to your reasoning and you will recover the loss. Once the time passes by, the stock moves against you even more. Your hesitation becomes stronger because you need to make up a larger amount now to realize even a slight loss. Some investors and traders, then move that stock to their long-term portfolio after they gave up the hope it would recover in a few days. I guess, this scenario or with some slight variations happened to a lot of us.
The asymmetry of a 50% percent loss in stock, and the subsequent recovery of 100% needed, for you to be at break-even, is a known relation to any stock trader and investor. This is another topic.
My point here is of a different nature: when you do short-term trading, you believe you have an edge for one specific stock of say 60%. So, you are slightly better than flipping a coin. But you must know that your edge works only after you repeat the experiment a couple of times, not to say a couple of hundred times. Once you see, the trade is running against you, you must close after a pre-set threshold is reached. Otherwise, one bad trade can ruin all your excellent work.
News cycles can wreak havoc on your losing trades
I always thought, once a growth stock is overvalued as Tesla was at a price-to-sales ratio above 15, all the good scenarios are already priced in. So, once news about what was already contained in the best-case scenario gets in, it should not move the stock more to the upside. What fatal thinking that was. Newly arriving pieces of news can move the stock up further, which again creates momentum and that again creates some news of the kind "stock X moved by y% in the previous weeks/days."
Wall Street analysts revise their price targets, only based on recent upward moves, not based on fundamentals. That brings in new short-term traders who think it can only go up from there. These cycles, if repeated a few times, can significantly diminish your savings or portfolio gains.
Shorting stocks as a hedge for your portfolio
Well, this one is tricky. It can work for a long time, just until the day it does not work anymore. Hedging works either through options which if done properly ensures that in certain price scenarios you can still buy or sell a stock or hedging works through mutual correlations between stocks or sectors. The classical example is to go long Mastercard and short Visa. The same way you can have a certain portfolio and say as a hedge you go short Apple or Tesla. So, when the markets go up you will profit from your portfolio and have a (hopefully small) loss on your short position. If the markets go down, you lose on your portfolio, but you will have some offset gains on your short positions.
The problem with hedging based on correlations is two-fold. Correlations are based on historical data, so the first question is how long do you go back to calculate the correlations? Secondly, correlations are only linear dependencies. And, thirdly, an existing, strong, and linear relationship might cease to be valid going forward because something drastically changed for one or the other stock. The latter exactly happened with my Tesla short. I initially bought it as a market downfall hedge. In the end, it turned out as a double-edged sword, because all my cyclicals were falling, and Tesla stock was rising. I did not have any growth stocks to alleviate the 2020 lockdown market sentiment.
Doubling down your position to increase the selling price
This is also a dangerous and very common one. To double down on your position when you intend to take a long-term position in a company is legit and I have done so many profitable trades with this strategy. The danger comes from applying this strategy to your short-term gambles that turned out to be unprofitable in the short term and it is related to the first point I mentioned: converting your short-term gamble into a long-term position. Well, do not double down on short-term positions. Especially, be clear before each trade which sort it is and then based on that initial decision, make restrictions if you can double down or not.
Shorting (growth) stocks because they are overvalued
Coming from the school of value investing and The Intelligent Investor (the initial book on value investing from Benjamin Graham) you might be tempted to look at valuations of some company and ask yourself doubtfully if you are missing anything or if it is just another market frenzy. You might wonder how a growth trajectory should look like to justify a certain price-to-sales or price-to-earnings ratio. The larger problem is that it can trade at elevated levels for an exceptionally long time. Another cautious tale is that it can even trade way higher than those initially high perceived levels.
In the same way, markets, as well as individual stocks, do not reverse to bear markets just because they are overvalued. They usually start a downfall upon certain unexpected catalysts or outside events. This could have been witnessed on the market level recently once the ten-year U.S. Treasuries reached 1.6% and 1.7%, coming from below 1% levels from last year.
The doom-laden articles you can read on the web do not give you necessarily a useful actionable insight, besides informing you how much the market currently is beyond historical territory. The market can go up another x% from that point and that period can take another few years until some catalyst emerges and breaks a long bull market. Take, for example, the Nikkei in the 1980s:
According to this paper, published in the Journal of Financial Economics, the price-earnings ratio of all Nikkei listed companies increased from 37.9 to 70.9 between 1984 and 1989. By the reasoning of most (value) investors, 37.9 is already very elevated. But, as you see, it still went up substantially. For reference, according to WSJ, the trailing 12 months P/E ratio for the NASDAQ 100 Index was 37 as of 12th March 2021 with a forward twelve-month P/E ratio of 28 (see the next figure).
Do not bet against a storytelling stock
Storytelling stocks are extremely hard to bet against. This is especially the case if there is a large follower base that blindly believes everything, they hear from a CEO turned Messiah. It is hard to trade against a fan base that does no contemplation about the uttered (tweeted) statements by the Messiah, nor about the inherent uncertainties or about the likelihood of said events to occur.
When Tesla's CEO tweets that the company is going to sell 20 million cars by 2027 or by 2030, that just becomes a catalyst for a new market high, without the buyers thinking critically about the likelihood of it actually happening. The fan base does not waste a thought on EV demand by 2027, nor the stress on electricity grids, nor the supply of lithium for such a high number of batteries. I recommend this SA article by the Kovacs brothers about the supply of silver, indium, and lithium. Then the media cycle as mentioned above starts again. Experienced investors then recognize the momentum, which adds further to the buy-side. Then a short squeeze of short-sellers might happen, which again turns the wheel from the beginning.
The point I want to make clear here is that once many small events happen to coincide and the formed snowball starts rolling downhill, it can easily become a self-feeding machine that turns into a large avalanche and gets out of control. That can happen with other stocks on a different scale. Not much is needed usually to get that snowball rolling downhill. Take the trend of green hydrogen recently that propelled Plug Power (PLUG) to some unjustifiable highs. Or the data science and data handling fantasies that propelled Palantir (PLTR) to the recent highs.
Before you discard my article as just another value investor only looking for low P/E ratios, stable cash flow, etc., let me tell you, I understand and accept the notion of growth stocks. At some point in the life cycle of a company, a growth stock becomes very large, so it is impossible to grow by the initial large growth rate and to keep on trading at elevated price-to-sales and P/E ratios. One sort of exception here is Amazon (AMZN), which managed with AWS to turn a whole new business segment into a growth machine. Thus, they were able to maintain an elevated P/E ratio over the previous years, even after having existed for over 26 years now, with 24 years of being a public company.
Also, the notion of being a growth stock does not mean it can swallow all kinds of fantasies about growth and market penetration with complete disregard of future competition.
Asymmetric incentives for institutional investors
Once, a trade gets all the attention, institutional investors slide into a dilemma and their motivation and incentives work in favour of buying a fashionable stock, even if they are aware of its overvalued status. They have a low incentive to short the market or a specific stock. So, when you are shorting a specific stock, the group from which you will be getting the least tailwinds is the group of institutional investors.
Their decision making looks like this in a bull market:
|long stocks||bull market prevails||(small) hero, big bonus, momentum on his side|
|long stocks||bull market reverses to bear market||no hero, but no job loss|
|short stocks||bull market prevails||looks like an idiot; loses his job|
|short stocks||bear market|| |
hero, big bonus, momentum working against him
Short squeezes are like a fire in the forest for short-sellers
This lesson could have been taken with improved live events unfolding more recently with the whole GameStop and AMC Entertainment trades. I will not go into more details about this topic because it just happened a few weeks ago and is still fresh in everyone's minds. The take-home message here is to know how dangerous short squeezes can be for a short seller.
The outlook for Tesla
Tesla has done an outstanding job in moving companies into EV production and potentially bringing great environmental benefits to the world. Its cars are high-end, premium quality cars. But and these are some large "buts": car making is a highly competitive industry, where lots of established players will soon catch up, where lots of new Chinese EV start-ups have risen to prominence. Many will not create cars with quality at par with Tesla, but they will eat a large chunk of its cake because these other cars will fill market niches and demand that Tesla physically cannot cover. Margins in the automotive sector are known to be 10% at best for premium brands. Tesla without the regulatory credits for last year, would not have been a profitable company in 2020.
Ask yourself if you consider investing long-term in Tesla: do you want to pay $600B for a company that might or might not earn one to two billion dollars in 2021. Even when Tesla reaches $100B in revenue and with an EBIT margin of 10%, their EBIT will be somewhere at $10B. I remind you, the company's revenue in 2020 was at $31B. How many years are needed to reach $100B? How will the EV market look at that time? Fundamentals will matter sooner or later. It is hard to keep a hype going for so long on Wall Street.
To short-term traders, I am wishing you good luck and sending a piece of advice to stick to your risk management principles.
(Source: Twitter; Tesla's CEO had his word on the company's valuation back on May 1, 2020, when Tesla stock was trading at $150 levels)
I remain bearish, but I strongly advise against selling Tesla short. The piece of advice is to those with less short-selling experience and with problems complying with their own risk guidelines. The reasons were elaborated above, but I would like to cite one last reason: if nothing else, then for the sake of your mental health since the volatility can damage your nerves.
This article was written by
Analyst’s Disclosure: I am/we are short TSLA, NIO. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.