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As part of our special series on short-selling, Fool contributors Tim Beyers and Rich Smith argue the pros and cons of selling stocks short.
I've been in favor of short-selling for as long as I've been an investor; 10 years at last count. In that time, I've taken the short side infrequently, yet usually to my benefit, cutting or even completely covering losses I'd created by buying poorly.
More broadly, I favor shorting because it helps grease the skids of the stock market. Buyers need sellers just as Jedi need Sith Lords, Fools need Wise Men, chocolate needs peanut butter, and strikeouts need home runs.
But shorting is more than a means for stabilizing the market. It's also a legitimate investing strategy practiced by experts. Take long-short mutual funds, which mimic hedge funds in their ability to take either the long or short side of a stock position, thereby increasing their ability to drive returns in any market.
Fools also like to short. Our co-founders, brothers David and Tom Gardner, offered a blueprint for shorting in The Motley Fool Investment Guide that persists to this day. Research In Motion (Nasdaq: RIMM ) drew the ire of one Foolish analyst back in 2005, when he saw shares of the CrackBerry maker rise to unsustainable heights. I took a similar position against RIM in Motley Fool CAPS last September and have soundly beaten the market since.
Most of the very top investors in CAPS short at least some stocks. Top Fool BravoBevo has closed several short positions that would have virtually doubled as real-money positions.
Best of all, finding stocks to short isn't as difficult as you might think. Stock spammers often tout barely legitimate businesses begging to be shorted, such as so-called "greencycling" expert Golden Spirit Enterprises, which promises technology for converting trash into energy.
Trouble is, Golden Spirit paid a stock promoter to tout its message. Proven revenue isn't enough, apparently. If you're thinking that I'd rather own shares of legitimately green businesses such as Waste Management (NYSE: WM ) or Covanta (NYSE: CVA ) , you're right. Combined, these two already operate more than 50 waste-to-energy facilities in the U.S.
Why short? In the end, because most investors don't, or won't, and because sustainable investing profits are never, ever created by following the herd. As David and Tom wrote in the Investment Guide:
"Once your [friends who don't short] find out you're shorting stocks, they may begin to regard you as Darth Vader. That's the impression most people have of short sellers. So what the heck? Divest yourself of your motley, put on some dark clothes, sport a low visor, breathe loud, and milk it."
Let me begin this debate with a concession: Tim's right. Shorting is a healthy part of a functioning, liquid market. But shorting is for suckers. It's not healthy for you. To the contrary, playing the short game can be hazardous to your wealth.
Here's an example: Just under five years ago, Tim and I were on these pages discussing the relative merits of Google (Nasdaq: GOOG ) . Tim argued that Google's stock was underpriced and ready to roar, given that it was growing faster than Internet peer eBay and selling for a cheaper price-to-earnings ratio than archrival Yahoo!. I argued the opposite -- that Google was worth barely a third of what the shares cost at the time.
I was wrong. (Obviously.) But I was even more wrong to entertain the idea of shorting stocks at all. Why? Because the odds of making money on this maneuver are stacked against you. Consider: If you sell one share of $10 stock short, how much money can you make if it falls to zero? Answer: $10. You sell the stock for $10, pocket the money. You buy it back at $0, and keep the money.
But what if the company works through its difficulties and rises to, say, $100 over the course of the next few years? (Don't laugh. Marked for bankruptcy and nationalization in the depths of the financial meltdown, Bank of America (NYSE: BAC ) has seen almost that big of a percentage increase since its 2009 lows, while Human Genome Sciences (Nasdaq: HGSI ) , written off as a lost boondoggle last year, has done even better.)
If that happens, you're in the unpleasant situation of being required to pay $100 to buy back a stock that you sold for $10. That's a 900% loss. This illustrates the central flaw in shorting as an "investment" strategy: Being absolutely right can earn you a 100% profit. Being wrong can cost you infinitely.
And it gets worse. Sometimes you can be 100% right about a stock yet still lose money by shorting it. For example, earlier this year Tim and I agreed that Palm (Nasdaq: PALM ) was essentially worthless. Short of cash, burning more, and with vast claims on its assets from preferred shareholders, common shareholders were due to receive not a dime in a Palm bankruptcy. But on April 29, Hewlett-Packard bought the company far above the $0 valuation I ascribed to it -- short-circuiting my short thesis before it had a chance to play out.
Moral of the story: Even if you're 100% right about a stock's short-worthiness, all it takes is one greater fool, with deeper pockets, to wipe you out.
Please take our Motley Poll and then share your short-selling experiences with other readers by leaving a comment below.