Forget Buy and Hold, Think Buy and Short

I'm going to let you in on a little secret. Most stocks stink.

And I'm not just talking about my personal portfolio, though I've owned plenty of terrible stocks in my life. No, most stocks really do stink.

In fact, nearly two-thirds of stocks will underperform a diversified index. That's according to a research study by hedge fund Blackstar Funds covering stocks traded on all three major U.S. exchanges from 1983-2006 (a very bullish period for the stock market).

What did Blackstar find?

  • 64% of stocks underperformed the Russell 3000 during that span, dividends included.
  • 39% of stocks had a negative lifetime total return. Two out of every five stocks lose money.
  • 19% of stocks lost at least 75% of their value. Almost one out of five is a really bad investment.

What's more, the mean compounded annual return of the 8,054 stocks in Blackstar's study was -1.06%. Think about that for a second. In what was considered a bullish time for stock returns, U.S. stocks on average actually lost money.

Nope, no silver lining here
Here's where you're probably expecting me to say: "But ignore all these bad statistics. You and I, we can find winning stocks. No problem!"

I hate to break it to you, but only a small sliver of stocks -- 14% to be exact -- delivered compound annual returns of greater than 20% during the period covered in Blackstar's study. That small cohort was responsible for almost all of the gains of the Russell 3000 from 1983-2006.

How hard is it to find a 20% per year winner? Of the 5,869 stocks on major U.S. exchanges, only 248, or about 4% of them, had compounded annual returns of 20% or more over the last 10 years.

Let's take a look at few of the big winners:

Stock

10-Year Annualized Return

Hansen Natural (Nasdaq: HANS  )

54%

Green Mountain Coffee Roasters (Nasdaq: GMCR  )

49%

Quality Systems

42%

Middleby (Nasdaq: MIDD  )

34%

Goldcorp (NYSE: GG  )

27%

Apple (Nasdaq: AAPL  )

27%

Penn National Gaming

23%

Data from Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Granted, Apple was already a household name in 2000, but that was pre-iPod and iPhone, and competitors like Dell and Gateway were eating Apple's lunch in the personal computer market. If you were savvy enough to spot the gold trend before it really started to take off and ride Goldcorp to huge gains, more power to you. The other names on the list were all small companies back in 2000, and probably not on most investors' radars.

All of this is to say that, out of a large universe of nearly 6,000 stocks, the chance of having even minimal exposure to any of these 248 big winners was slim to none.

History hates winners
Let's go back even further. Imagine it were 1980 and I told you that in 30 years, Eastman Kodak, Bethlehem Steel, General Motors, Emery Air Freight, Polaroid, and Xerox would either be bankrupt or be trading for less than they were in 1980. You would have called me crazy. These were some of the leading companies of the day.

Look back at that table above of the past decade's big winners. Are Apple, Goldcorp, Hansen Natural and Middleby likely to repeat their great performance of the past decade?

  • Apple would need to sell somewhere on the order of 1.2 billion iPhones over the next 10 years.
  • Goldcorp's annual production would have to increase by 11 times (not happening) or the price of gold would need to rise to $13,100 (possible, but let's get real).
  • Hansen Natural would need to work its way up to selling some $90 billion worth of its Monster beverages every year by 2020. That's three times Coke's current annual sales!
  • Middleby would have to sell $11.2 billion worth of commercial ovens and equipment. How many restaurants are there in the U.S.?
  • Green Mountain Coffee roasters would need to sell $65 billion worth of coffee machines and coffee every year by 2020, more than six times Starbucks' current annual sales!

Just look at a few of the big winners from 1983-2006 in Blackstar's study: American International Group (NYSE: AIG  ) , Bear Stearns, Citigroup (NYSE: C  ) , Fannie Mae, and General Motors. Since then, one of those companies went bankrupt (GM), another was put into receivership (Fannie), while the other three each lost more than 90% of their value. Bear Stearns was bought out by JPMorgan for a fraction of its previous value, and there's still a very real chance that AIG and Citigroup face further losses. AIG still owes the U.S. government $102 billion for its massive bailout and any cash it can squeeze from asset sales and its beleaguered insurance operations may not be enough to cover the deficit. Citigroup's above-average exposure to consumer banking makes it extremely vulnerable to more pain in the housing market and new restrictions on consumer credit thanks to the financial reform act.

Big winners. Now big losers. Kind of makes you question the pure 'buy and hold' approach, doesn't it?

Stop trying to find winners
How many of us are actually smart enough and lucky enough to find those 4% of stocks that will turn out to be big winners? Very few. In fact, you'd be very fortunate to just find one long-term 20% winner in your lifetime.

So we shouldn't spend so much of our time looking for big winners. Instead, let's put the odds in our favor and focus on the 64% of stocks that stink. We may even come across some of the really ugly ones -- the  one out of five stocks that will go on to lose 75% of their value. Heck, the odds of finding a big loser are almost five times the odds of finding a big winner!

Now, I'm not suggesting you dump all of your long positions and just start shorting stocks. After all, if there weren't great returns to be made buying individual stocks, we'd all stand to make a lot less money and … well, I'd be out of a job.

What I'm suggesting is that you set aside a chunk of your portfolio for shorts. That will act as a useful hedge against your favorite long positions and give your portfolio a critical ballast during tough times in the market. Just imagine if 20% of your portfolio would have been short going into the 2008 market crash. Imagine how much better we all could have done.

If you are looking to short individual stocks for big gains, enter your email in the box below. I'll also send you our latest research the instant it is published plus I'll send you a brand new report, "5 Red Flags -- How to Find the BIG Short," free right now.

Matthew Argersinger doesn't own any of the stocks mentioned in this article. Green Mountain Coffee Roasters and Hansen Natural are Motley Fool Rule Breakers recommendations. Apple and Quality Systems are Motley Fool Stock Advisor selections. The Motley Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (57)

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 August 10, 2010, at 11:57 AM, TigerPack1 wrote:

    Along this line of reasoning, some of the top stock picking minds on CAPS have been working on long/short designs for a real world portfolio and/or new mutual fund or hedge fund product. UltraLong, bullishbabo, anticitrade and myself are working with TMFJake on getting another Live Chat going in a week or two to discuss our progress the last four months, and 6 experimental portfolios we are running at Wall Street Survivor. Stay Tuned!

    -TigerPack

  • Report this Comment On August 10, 2010, at 6:51 PM, lebaresq wrote:

    High current yields are my primary focus, capital gains secondary. If you get 8% payout yield to start with, you only 2% annual gain to meet magical 10% long-term growth average so frequently cited in long-term stock investing. No need for exotic options strategies.

  • Report this Comment On August 10, 2010, at 7:46 PM, mtracy9 wrote:

    "In spite of all the great and minor calamities that have occurred this century -- all the thousands of reasons that the world might be coming to an end -- owning stocks has continued to be twice as rewarding as owning bonds. Acting on this bit of information will be far more lucrative in the long run than acting on the opinion of 200 commentators and advisory services that are predicting the coming depression." --Peter Lynch

    http://shouldersofgiantsinvestor.com/

  • Report this Comment On August 11, 2010, at 1:20 AM, aeneas2009 wrote:

    lebarsq,

    explain further,please!

  • Report this Comment On August 11, 2010, at 1:34 AM, ChrisBern wrote:

    Couldn't agree more with the premise of this article. Even if you're not 50/50 long/short, and I would guess that most people aren't, it pays to have at least a few short positions on a few horrible companies. Then if the market tanks, those shorts will soften the blow to your overall portfolio. That also allows you to sell the shorts at a major profit, and use the proceeds to buy a GOOD company at a now-low price. A 100% long portfolio never lets you buy more as prices drop. Great article!

  • Report this Comment On August 11, 2010, at 2:51 PM, Classof1964 wrote:

    I would appreciate it if someone would spell out the process by which selling shorts and the underlying stock if the market falls will make up the money lost. My current understanding is that I would get a small amount each time I sell a short (which is for a period of time, 3 months?).

    Then if the market drops and I sell the underlying stock, I'll get whatever value it brings, even if only 25% of my original basis. So am I correct that the suggested procedure returns a fraction of my original investment, depending on how much the stock has fallen? Perhaps someone could give a concrete example.

  • Report this Comment On August 13, 2010, at 2:24 PM, campbell2457 wrote:

    Classof1964,

    You may be confusing selling call options with selling short. Two entirely different strategies.

  • Report this Comment On August 14, 2010, at 3:38 AM, philkek wrote:

    Thanks MF and fellow fools. Good article and comments. I've learned a little more about how to make money from Mr. Market. Better Business Bureau warns fools to investigate BEFORE we invest. Fool on for profits.

  • Report this Comment On August 15, 2010, at 11:10 PM, jlclayton wrote:

    Classof1964:

    Shorting a stock means that you actually sell shares of that stock without owning any. If you believe that a stock is overvalued and likely to drop, you could sell, say 100 shares without actually owning any yet and that would be "shorting" the stock. Then you would later buy 100 shares to close your position and go back to zero. If the stock has dropped as anticipated so that you can buy it at a lower price, you've made money.

    It can be a risky move due to the fact that there is unlimited risk. For example, if you buy a 100 shares of a $20 stock and it goes to $0, you have lost your entire investment of $2,000, but you knew your maximum risk was $2,000. However, if you short a $20 stock and suddenly news comes out that shoots the stock price up to, say $50, your loss is now $3,000 and can keep rising. That's what makes shorting stocks the riskier investment and why many don't like to do it.

  • Report this Comment On August 25, 2010, at 4:59 AM, seagull2912 wrote:

    Selling deep in the money Cover Calls or vertical Debit Spreads is an equivalent to shorting stock. It is actually used by most institutional traders and very well known as a hedging. There is no up side risk involved as oppose to the necked short stock. It is not popular on the Fools Talk but it is an investment instrument I would say any investor should be at list aware of. I am using it in combining with naked short putt an expiration no further then 2-3 month. It works! Just in case to let everyone to know the Naked Putt is a identical twin of the Cover Call.

    Good free education provided by OIC (Option Industry Counsel) Live Seminars provided national wide and it finance by Option Clearing House according SEC requirements see schedule & more information on their web site www.OptionsEducation.org

  • Report this Comment On September 15, 2010, at 4:06 PM, Glycomix wrote:

    Shorts are selling borrowed stock from the broker. You have only a few days to give it back. Unless you know that a stock is going down it doesn't make sense to short.

    Every time I've shorted a stock I've lost my shirt. It takes someone smarter than me to short.

  • Report this Comment On October 05, 2010, at 8:26 PM, Glycomix wrote:

    You can short stock for weeks at a reasonable rate. Shorted stocks are borrowed, but some brokers have more stock to lend than others and charge a fee for lending the stock. I was wrong about the deadline in my above posting.

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