Is Shorting Stocks Foolish?

There's been a fair amount of coverage on Fool.com recently regarding shorting stocks. Even true-blue, long-only investors like me have been talking up the idea of shorting. But loyal Fool readers may be wondering whether shorting is really Foolish.

The Fool has long been a cheerleader for individual investors doing their own investing and encouraging the long-term ownership of high-quality companies. That is, investing as if you were taking an ownership stake in the business.

When a stock is shorted, an investor borrows shares of stock and sells them. That investor is then hoping that the stock will decline in value so that he can buy it back cheaper than he sold it and pocket the difference.

The two don't seem to compute, do they?

But what is Foolish?
The name "The Motley Fool" and the jester logo weren't just pulled out of a hat labeled "confusing things to name your financial community" -- there's a very specific meaning behind them. As told in Foolish lore:

Our name comes from Act II, Scene vii, of Shakespeare's As You Like It. In Elizabethan drama, only Fools could speak the truth to the king without losing their heads. David and Tom Gardner founded The Motley Fool, Inc. in 1993 to help people make better financial decisions by exposing the shams behind the conventional Wall Street "kings."

In Roger von Oech's classic on creativity "A Whack on the Side of the Head," he has an entire chapter dedicated to the art of being foolish (though we capital "F" Fools would recognize it as also being Foolish). Speaking in particular about the medieval fool, von Oech writes:

 

The king's advisors were often "yes-men" who told him exactly what he wanted to hear. The king realized that this wasn't a good way to make decisions. Therefore, he gave the fool a license to parody any proposal under discussion and to shatter the prevailing mind-set. ...

The fool operates in a world that runs counter to conventional patterns. Everyday ways of perceiving, understanding, and acting have little meaning for him. He'll extol the trivial, trifle the exalted, and parody the common perception of a situation.

This is beginning to get a little interesting, eh? It sounds like to be Foolish -- if I can be so bold -- is to constantly be questioning the status quo. In fact, it would seem that to say that there's a set-in-stone, single way to be Foolish would be practically the epitome of being un-Foolish!

A Fool and his shorts
Now that we've laid out what it means to be Foolish, part of me wonders what could be more Foolish than shorting a stock? OK, maybe we won't go there, but think about it for a moment.

Short-sellers dig deep into companies' Securities and Exchange Commission filings and listen to everything management has to say, questioning everything along the way. Why did the margins jump like that? Where did that top-line growth come from? Should inventory be growing like that? Why in the name of Christopher Walken is this CEO being paid that much?

If you can picture a motley-capped jester dancing around, peppering those questions, and really letting a company have it when something doesn't add up, then we're on the same page.

And let's not forget, The Motley Fool's mission is "to educate, amuse, and enrich." So if our detective work yields a profitable opportunity to bet against a company that has set itself up for a fall, well, why pass that up?

A Fool meets Holmes
Now you could start just questioning every company out there. And, in fact, even if you're looking at a stock as a potential long investment, asking a lot of questions is never a bad thing. However, if we're looking for good places to flex our shorting muscles, there are clues we can look for that can lead us to potential short opportunities.

One red flag that can lead to short opportunities is a big jump in profit margins. I know what you're thinking, "Aren't higher margins a good thing?" Yes, they are -- usually. But sometimes a jump in profit margins could be a signal that something unsustainable is going on behind the scenes.

For example, companies may take reserves against losses in one period and then reverse those reserves in future period. Big banks like Bank of America (NYSE: BAC  ) and JPMorgan Chase (NYSE: JPM  ) have taken huge provisions against credit losses stemming from the lending boom.

If, down the road, they decide that they're not going to experience losses as high as previously expected, they could reverse some of those provisions. That would boost profit in the future period, but not represent a continuing source of profit. If investors get too excited about such a jump in profitability, it would set up short-sellers to profit from the inevitable reversal when the banks ran out of excess reserves.

My, what big margins you have!
To kick-start our search for companies that may have something funny going on behind the numbers, I've dug up five companies that have seen a big jump in their operating margins over the past year.

Company

LTM Operating Profit Margin

Year-Ago LTM Operating Profit Margin

Change in Operating Profit Margin

Unisys (NYSE: UIS  )

9.6%

3.7%

159%

Activision Blizzard (Nasdaq: ATVI  )

17%

6.8%

152%

Corning (NYSE: GLW  )

20.6%

9.1%

125%

Western Digital (NYSE: WDC  )

15.8%

8.3%

90%

CNO Financial (NYSE: CNO  )

7.8%

4.4%

76%

Source: Capital IQ, a division of Standard & Poor's.

As I noted above, these numbers are nothing more than starting points for further analysis. It's crucial for investors to pour a big cup of coffee and get intimate with SEC filings to determine where these profitability gains are coming from and whether they're sustainable.

In the case of insurer CNO Financial, for example, the company's investments took a big hit in the wake of the financial meltdown, and part of the recent improvement has had to do with fewer losses and more investment income. In addition, Coventry discontinued a line of business that it partnered with CNO on, and that happened to be one of CNO's less profitable business segments.

Potential short-sellers would want to watch the company's investment portfolio mix for signs that income might start moving in the wrong direction. In addition, if the company begins to chase less profitable business, it's possible investors may not appreciate the potential margin contraction.

Western Digital, meanwhile, benefitted from a big boost in gross margin that it attributed to volume, the mix of products it sold, and industry pricing. As the company competes in a cutthroat industry that's largely commoditized, it would seem like these gains would be tougher to hold on to. (Based on the stock's current valuation, it appears that investors are pretty skeptical.)

Similar to Western Digital, Corning's profitability jump came largely from higher volume -- in its case from sales of glass for LCD TVs, notebook computers, and desktop monitors. Unisys gained ground through cost-cutting and selling more of its ClearPath mainframes. Activision-Blizzard's gains came from a scattered array of favorable product mix changes, lower royalties and marking expenses due to fewer game releases, and some headcount reductions.

But as with CNO and Western Digital, investors need to be careful to pick apart these gains to figure out whether the higher margins are really sustainable.

Keep Foolin'
The companies and thoughts above give a good idea of how to approach shorting stocks Foolishly. In short, though, the formula all boils down to always asking questions. The more you question assertions, challenge numbers, and play detective, the more likely you are to find a prime-time short candidate.

If you'd like some help getting started, forensic accounting expert and fellow Fool John Del Vecchio has put together a special report, "5 Red Flags -- How to Find the BIG Short." If you'd like to check out a copy of this report for free, just put your email address in the box below.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. Activision Blizzard and Coventry Health Care are Motley Fool Stock Advisor selections. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Fool's disclosure policy assures you no Wookies were harmed in the making of this article.


Read/Post Comments (13) | Recommend This Article (7)

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 14, 2010, at 1:40 PM, moremoney4u wrote:

    Good article. With regards to Unisys' profit margin, this company is undergoing a major shift in how it does business. Before Mr. Coleman their CEO started with Unisys, their "low cost labor pool" was around 15% of all employees. Today, I believe they are around 26% with a stated goal of 35%. This isn't good for American workers or the unemployment rate, but it is good for Unisys' profit margin. They're only doing what other companies have already done with their workforce. In addition, Unisys has focused more on four major areas and have sold off at least three business groups, the HIM group being the largest which was sold for $135 million. This generates money for them to pay off their debt. These changes are fundamental and I don't expect any let down with regard to their profit margin. If anything, better times are ahead for Unisys.

  • Report this Comment On September 14, 2010, at 2:43 PM, pondee619 wrote:

    Is shorting foolish? Maybe, maybe not. But how many ways are there to invest where you can lose mulitples of your investment? A long can go to zero and you lose 100%. A short can increase 10 time to infinity. How many "10 baggers" are touted here turning a $100.00 short into a $1,000.00 loss? Shorting might be foolish, it sure is dangerous.

    P.S. is the increased fool coverage of shorting a contra indicator telling us that the next bull market is just around the corner?

  • Report this Comment On September 14, 2010, at 2:56 PM, deltafox2 wrote:

    Shorting is for traders (that's where "losing one's shorts" comes from?). Wasn't someone saying there are only wealthy investors and hardly any wealthy traders? Depends on your style of investing. If spending the day in front of a PC screen watching your short term trades developing is your thing then shorting may be ok for you. It's not my thing. The amount of shorting articles coming up in TMF is indeed unusual.

  • Report this Comment On September 14, 2010, at 5:22 PM, TMFKopp wrote:

    Thanks for the comments folks!

    @pondee619

    Can you lose big by shorting? Sure. But there are a few things to consider. First, there's nobody that's going to be holding your buy-to-cover finger away from the computer, so you're free to cover after a certain loss level. I'm not a fan of stop-losses when it comes to buying stocks, but when it comes to shorting I think you're probably best off backing off after a certain loss level.

    You also lower your risk of a huge shorting loss by carefully choosing your shorts. This means avoiding things like betting against high-flying momentum stocks and stocks with heavy short interest.

    As for the short coverage being a contrary indicator, if you look back at my shorting articles you'll notice that I'm not coming at it from a bearish perspective. I actually think now is a good time to own stocks -- particularly large dividend payers. I do, however, think that there are good short candidates out there that can offer a different type of exposure for your portfolio.

    Matt

  • Report this Comment On September 14, 2010, at 6:10 PM, TMFKopp wrote:

    @deltafox2

    "Shorting is for traders"

    Eh, I think that's a bit knee-jerk. I will concede that shorts are generally going to be shorter-term moves than buy and hold long investments, but I think someone thinks of himself (or herself) as an investor can short without forfeiting that title. I think many investors go where opportunity is -- John Paulson, David Einhorn, etc. I doubt they'd refer to themselves as traders or simply short sellers but both have done well by leveraging short selling as part of their overall strategy.

    Matt

  • Report this Comment On September 14, 2010, at 6:12 PM, TMFKopp wrote:

    @truth

    I appreciate your comments and you know that we're on the same page when it comes to dividend stocks.

    Frankly, short selling just isn't going to be for everyone. I tend to be of a very cynical mindset -- that actually led me to dividend stocks (if you're paying a sustainable cash dividend you're probably doing something right) and it makes shorting resonate with me as well.

    I don't think that every investor should jump into shorting, but I do think that many should at least give it consideration, because I think many -- like me -- haven't given it much of a thought in the past.

    Matt

  • Report this Comment On September 14, 2010, at 8:35 PM, xetn wrote:

    While I don't have a problem with the concept of shorting, I do have a problem with the level of risk. It seems to me that TMF has been pumping the idea of shorting to sell yet another high priced subscription. Again, I don't have a problem with your sales techniques. You have every right to maximize your income from whatever method you can dream up.

    However, it seems to me that you can obtain the relatively large gains that can be had by shorting with much lower risks with options. Wasn't this one of the big "selling features" you promoted last year with your options subscription?

  • Report this Comment On September 14, 2010, at 9:07 PM, TMFKopp wrote:

    @truth

    Loved it. I especially liked his "dividend drill" model -- I've incorporated that into my array of models. I could quibble that that the growth rates are a little simplistic and assume flat growth through perpetuity, but it's a simple model and I like that about it.

    Yeah, overall a really great read.

    Matt

  • Report this Comment On September 14, 2010, at 9:19 PM, TMFKopp wrote:

    @xetn

    I'm not exactly sure who you're addressing, but TMF isn't one big homogeneous organization. As I noted in an earlier response to a similar comment of yours, I actually don't write about options. (I don't think there's anything wrong with them, I just don't use them and I don't have a burning desire to start)

    And frankly, nobody says you have to sign up for anything in this article. You can take what's here -- which is the idea that shorting, or at least having a short-seller mentality, is, I believe, Foolish and can provide some nice money-making opportunities -- and do with it whatever you like. And yes, you certainly can take a short stance on a stock and capitalize on it through options.

    Or you can short sell. Or you can grab John's report and use options. Or you can navigate away from the page and do nothing at all. Or you can mix and match all of the above options (or do something that I haven't thought of that involves rubber chickens or an autographed Giants jersey).

    Bottom line -- yes, you're correct that we're launching a new service around short selling, but the article here is intended to offer stand-alone value and hopefully it does that.

    Matt

  • Report this Comment On September 15, 2010, at 5:21 AM, Kiffit wrote:

    I do not get it. A short position is an investment that is leveraged up by additional margin (which reduces profitability) and it has an unlimited risk down downside. Buying a put option, or preferably a put vertical spread, gains huge negative investment leverage up front (small investment exposure on a large number of shares, which ramps profitability) with a small risk exposure (because even if the investment totally tanks, you only lose the value of the options). And just like a short, if it goes against you, you can always trade out if there is any value left in the trade.

  • Report this Comment On September 15, 2010, at 9:16 AM, pondee619 wrote:

    " yes, you're correct that we're launching a new service around short selling,"

    OK. So the onrush of shorting "articles" is not a contra indicator (or any indicator) on the market, nor a timely series of stories, but the harbinger of a New Service.

    @Matt. I'm not concerned, necessarily, with "your stories". Its the rush of "stories" from These Motley Fools that has me concerned. "TMF isn't one big homogeneous organization" (and yet you call yourself THE motley FOOL and not THOSE/THESE Motley FoolS) however, you do seem to fly as a flock. Now that there will be a new shorting service, there is a marked increase in the subject.

    Where, in your "story", was the discussion of the risks involved in shorting?

    "You also lower your risk of a huge shorting loss by carefully choosing your shorts" Duh

    "I'm not a fan of stop-losses when it comes to buying stocks, but when it comes to shorting I think you're probably best off backing off after a certain loss level" So, shorting is more dangerous that being long?

    However, a fool writer recently poo-pooed the danger:

    By Jim Royal, Ph.D September 14, 2010;

    "Pop quiz, hotshot! How many stocks have you seen climb to infinity?

    (I haven't seen one either.)"

    A short does not have to "climb to infinity" to be devastating.

    Shouldn't these advisos be part of your main story and not just a follow up?

    Shorting, is contrary to the fool (These Fools) way of investing as set forth in your "13 Steps to investing". While you are free to start up a new service I urge you (These Fools) to advocate caution, more so than currently done.

  • Report this Comment On September 15, 2010, at 4:19 PM, TMFKopp wrote:

    @pondee

    "however, you do seem to fly as a flock. "

    I know you read a lot of our coverage pondee, and I know you know that's not true. One example: http://www.fool.com/investing/general/2010/09/03/should-you-...

    "Where, in your "story", was the discussion of the risks involved in shorting?"

    This article was specifically about whether shorting is Foolish. It was not meant to cover every aspect of shorting so the fact that I don't specifically talk about the risks doesn't mean that there are no risks.

    "Shorting, is contrary to the fool (These Fools) way of investing as set forth in your "13 Steps to investing"."

    Do you want to get a little more specific?

    As for your whole "These Fools" thing, The Fool is a community, Fools are part of that community. The Fool has no sacred cows (it's Foolish... as I discuss above). The Fools that are part of The Fool community are free to -- and encouraged to -- disagree with each other and say what's on their mind.

    Matt

  • Report this Comment On July 26, 2011, at 2:50 AM, joepennies wrote:

    Hi. I totally agree that shorting stocks is foolish and I also agree with what pondee619 about the potential to lose 10 times your investment.

    I specialize in penny stocks (and small caps to a lesser degree) and I am alarmed at all the hype right now about shorting penny stocks. This is foolish with multiple exclamation marks!! I recently wrote an article about this on my blog entitled, "How To Make Money Shorting Penny Stocks - NOT!" Here's the link: http://how-to-make-money-with-penny-stocks.blogspot.com/2011...

    Joe Wolfe

    http://how-to-make-money-with-penny-stocks.blogspot.com/

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