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4 Reasons Not to Short Stocks

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Selling stock shorts can be fun and profitable, but it's a very risky strategy. Most stocks go up, the cost of being wrong is huge, even being right might not be profitable, and brokers charge big fees for you to short. If you're not an experienced investor who understands all the risks, then you probably shouldn't be selling short. 

1. Swimming upstream
The most obvious, but perhaps most important, challenge in shorting is that, on average, stocks go up. Not every stock, and not every year, but the general trend is upwards. According to data from NYU-Stern Professor Aswath Damodaran, stocks in the S&P 500 have advanced, on average, 9% annually between 1928 and 2012. Thus, if you choose to short stocks, you're betting against the odds and history. 

2. Being wrong could be your ruin
It's often pointed out that shorting offers a maximum return of 100%, with unlimited potential to lose. In practice, your potential losses aren't unlimited (your broker wouldn't allow that), but you could completely wipe out your account. In other words, if you're wrong, you could lose everything. That's a pretty big risk, considering it's very possible that you could be wrong. In investing, nobody is right all the time. Even Warren Buffett has made mistakes and lost on investments. 

Here's a real-life example of how it's really easy to be wrong. Let's say you were examining a company about a year ago. The company had generated large losses for five years. Its strategy was to enter an industry dominated by a few huge incumbents, which had dominated the industry since World War II or earlier. The company was developing an entirely new, very complex product from scratch. The endeavor would require huge amounts of capital, and the company's ability to raise further capital was unknown. Finally, the size of its target market was uncertain. At best, it would cater to a large niche, and at worst, nobody would want it's products. Its founder and CEO was talented but also invested in other non-related projects. And this company had a market capitalization north of $3 billion. A reasonable analysis might have suggested that this company was a money-loser, it was on a quixotic mission, and it would never succeed. In other words, a good short candidate. That's what a lot of professional, well-informed investors thought at the time -- short interest on the company was nearly 30%. 

If you hadn't already guessed, I'm talking about Tesla Motors (NASDAQ: TSLA  ) , which is up more than 460% over the past year. Elon Musk and company defied the odds and met or exceeded challenging milestones, and market sentiment shifted radically. The stock went on an incredible bull run, perhaps with a few short squeezes along the way. If you had shorted the stock, you would've been destroyed. Even though your initial case against would've been completely reasonable, it didn't work out. You were wrong, along with a lot of other investors. And, since it was a short position, your losses would be catastrophic. Obviously, this is a cherry-picked example, but it illustrates the huge risks associated with shorting. 

3. Being right doesn't guarantee success
Let's consider David Einhorn's battle with Allied Capital. In 2002, Einhorn publicly pointed out accounting irregularities with the company. Einhorn had a strong case and the bully pulpit. Allied Capital's stock took an initial dip after he shared his thesis. But the stock proved resilient, rising over the the next few years. Along the way, there were numerous tribulations for Einhorn. Instead of investigating Allied Capital, the SEC investigated Einhorn. Allegedly, Allied Capital stole Einhorn's phone records. His wife lost her job at Barron's. Einhorn eventually wrote an entire book on Allied Capital. By 2007, Einhorn was vindicated -- the SEC found fault with Allied Capital's business practices. Its stock fell below his short price, but the profits for his fund were small, especially relative to the time, effort, and aggravation involved.  

Of course, Einhorn is a famous hedge fund manager who publicly shared his case, thus inciting a battle with the company. As an individual short-seller, you won't experience all the problems he had. But, it can still be hard. In January, I wrote a critical article about ParkerVision (NASDAQ: PRKR  ) . It's a small, Jacksonville, Fla.-based company that has virtually no business operations. It's been in business for 20 years without ever generating a profit. To keep itself afloat, it regularly raises equity from new investors, thus diluting existing investors. The primary beneficiaries of this non-business are its CEO, Jeffrey Parker, and his cronies in management. Even as the business loses money and shareholder value is destroyed, they keep getting paid. At present, the company's primary reason to exist, aside from lining the pockets of management, is to litigate patent claims against Qualcomm. In my opinion, the company's claims are largely hype, and its only chance to win a claim is legal incompetence (or favoritism). In August, I reiterated the case against the company, pointing out its continued cash burn. In all, there's a very solid case against this company. But that hasn't stopped the stock from running up. Year to date, the stock is up 65%. In the end, it's proof that as a short-seller you're subject to the whims of the market. Even the worst, most questionable stock might stay flat or even increase, in spite of common sense and a rational thesis. 

4. The costs are very high
Short-selling is expensive. It depends on your broker and the stock, but there can be borrowing fees. If you use shorts to increase your gross investments, then you'll pay interest for using margin. Also, as a short-seller, you're responsible for paying the dividends associated with any stock you borrow. That can be expensive.

Last week, a research firm called Hedgeye suggested that investors short the shares of Kinder Morgan (NYSE: KMI  ) and Kinder Morgan Energy Partners (NYSE: KMP  ) . In short, Hedgeye analyst Kevin Kaiser alleged that both companies were a "house of cards" that under-maintained their assets and manipulated their financial results. His recommendation is to actively short both companies without any specific catalyst that will cause the stocks to fall. Aside from the fact that his accusations are complete hogwash, this is a foolish suggestion. Those two companies pay respective dividends of 4.5% and 6.6%. In other words, in addition to borrowing fees, margin costs, and trading commissions, you'll need to pay 4.5% and 6.6% of your investment annually out of you account to maintain the position. 

Foolish bottom line
The best way to generate returns in the stock market is to buy high quality business at a good price and hold for the long term. Shorting is challenging and risky, and most investors shouldn't do it. That's not to say it can't be profitable or useful as a hedge, but it should be done only by experienced investors who fully understand the costs and especially the risks. Even experienced investors should be selective, cautious, and careful about shorting. It's a tough way to generate returns. 

The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


Read/Post Comments (10) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 15, 2013, at 1:51 PM, NoFoolInvest wrote:

    Excellent insight. I have been there and totally understand your four points of view.

    Sum up, the market is irrational.

    However, there are still many people playing options including shorts. I bet that most of them lost money before but still gambling on it.

    The question is how a few experience people including some hedge fund managers make it successfully?

  • Report this Comment On September 15, 2013, at 10:51 PM, pvnotes wrote:

    Good article. I agree with both of you main points: shorting is hard, and ParkerVision will (eventually) be a profitable short. Recent court rulings have been negative for PRKR, and I expect more negative ruling in the next week or two. I think the judge is finally starting to get it.

    Feel free to contact me if you ever want to compare notes.

  • Report this Comment On September 16, 2013, at 11:50 AM, laser1951 wrote:

    Why is shorting legal? What positive effect does this gambling add to the stock market or the economy? If you have faith in a company buy their stock, if not don't.

  • Report this Comment On September 16, 2013, at 2:17 PM, RobertBaillieul wrote:

    @laser1951 Price discovery. If a stock is overpriced, why not allow the smart money to bet against it.

    Though I agree with the author - short selling is incredible difficult to pull off even if you're right.

  • Report this Comment On September 16, 2013, at 6:33 PM, dennyinusa wrote:

    laser1951

    You nailed it.

    This is just gambling not investing.

  • Report this Comment On September 21, 2013, at 7:20 PM, ColorMeSkeptical wrote:

    If I'm wanting to buy a stock, I'm thankful for the existence of short sellers. More sellers in the pool means a better price when I buy.

  • Report this Comment On September 23, 2013, at 1:11 PM, MelissainVA wrote:

    Brendan,

    Wondering if I can get you to define what "shorting" is? I ask because I've seen many definitions. Some define it as borrowing money to cover margins and options, others as any trade that holds a stock less than a year?

    While I don't and won't borrow money to bet against a stock, I do occasionally sell when I think a stock is over priced and so far, I richer for it.

  • Report this Comment On September 23, 2013, at 4:23 PM, TMFWillSommers wrote:

    Hi MelissainVA -

    Hopefully this link will answer your question:

    http://www.fool.com/FoolFAQ/FoolFAQ0033.htm

    Regards,

    Brendan

  • Report this Comment On November 13, 2013, at 6:25 PM, thidmark wrote:

    "This is just gambling not investing."

    And that's exactly what Americans want. Look at all the lotto drawings and the explosion of casinos around the country.

  • Report this Comment On February 02, 2014, at 10:08 AM, wmcboston wrote:

    You guy nailed it !!

    Yep, shorting stocks should be illegal.

    Also, investigative journalism should be illegal.

    We all need to be nice and remember the wisdom shared by Thumper's mommy in the movie Bambi:

    "If you can't say something nice, don't say nothing at all".

    How dare a person question the validity of a company or question the validity of another person !!

    So what if you learn that the CEO was indicted on a fraud charge years before.

    Past performance is NOT indicative of future performance, right!!

    Can't you learn from your lessons-- and know any better?

    Can't we all just get along?

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Brendan Mathews
TMFWillSommers

A Fool since 2005, Brendan is a research analyst on The Motley Fool's Stock Advisor newsletter. He enjoys scouring financial statements, pontificating on competitive advantage, and any outdoor activity.

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