You Should Be Shorting Stocks

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What's the best way to become a great investor? Copy one. Here's what Ken Heebner, portfolio manager of CGM Focus (CGMFX), the second-best performing fund of the past decade, wrote in his latest letter to shareholders: "Approximately 8% of the Fund's total net assets were invested in securities sold short on December 31, 2007."

That's right. The man who has beaten Warren Buffett and Charlie Munger at the investing game since 1997 -- 26.1% versus 11.9% annually -- was shorting the financial services industry at the end of last year. His targets included Ambac Financial (NYSE: ABK), Countrywide Financial (NYSE: CFC), and Freddie Mac (NYSE: FRE). Look at what's happened since.

Profit in every market
But I intend less to celebrate Heebner's genius than to make this simple point: Investing is for every type of market. You just have to figure out where the profits are.

Most pundits will tell you that such a search is a fool's errand. I disagree. It's a Foolish errand, as Heebner proves. Hibernating during a bear market certainly can preserve capital, but by doing so, you'll lose time in the search for outsized returns.

Put differently: If you could get a 70% return in three months, would you take it? That's what Heebner appears to have achieved by shorting Ambac. And on the long side, he's profiting with Nucor (NYSE: NUE), Potash Corp. (NYSE: POT), and Mechel (NYSE: MTL).

Go hunting for stocks to short
To be fair, few of us have the time or experience that Heebner has. And shorting -- betting that a company's share price will fall in the future -- is a dangerous business, since losses can be infinite. But there are some simple principles for successful shorting that David and Tom Gardner first introduced in The Motley Fool Investment Guide. To review:

1. A high debt-to-cash ratio with low cash flow. David and Tom explain that if "expansion isn't coming from the existing business, or if that core business slips up, growth through debt becomes unsustainable."
2. Short "closed" situations; avoid "open" ones. Businesses with an innovative streak, or that are prone to surprising Wall Street, can quickly become multibaggers and break the back of a short-seller.
3. Short stocks with low short interest; definitely avoid those with high short interest. Selling pressure can build quickly when short interest is low. But as it rises, pressure builds for bears to collect their gains, which means more buying and a rising stock price.

Not too hard, right? Right. Now, the next step in hunting the market's walking wounded -- screening for ideas -- is easy, thanks to our 92,000-strong Motley Fool CAPS community. There, you'll find lists of high- and low-rated stocks and all the data needed to test them as potential shorts.

Consider Bear Stearns (NYSE: BSC). It's been a one-star stock in CAPS for months. All-Star investor fOOLSONPARADE put it this way last June:

The news hype following [Bear Stearns] is one of the most important financial issues right now. Why? Because there are a lot of CDOs that are being repriced and many other hedge funds that stand to lose substantially; [Merrill Lynch], [Bear], [Lehman Brothers], etc. Too bad [The Motley Fool] does not address this. It is in their best interest to steer investors and this credit market issue has far reaching implications for the market and many [Motley Fool] stock picks.

You'll forgive me if I think that last bit is misguided. But the rating was absolutely spot-on. Great call, fOOLSONPARADE.

Want more short ideas? Try the low-rated stock list at CAPS, which you can organize by active picks, bullish and bearish calls, and total return. It's 100% free.