Sure, the idea of short-selling stocks can be enticing for investors who strongly believe a company is overvalued and due to drop in price. It's also enticing to short stocks to make money even if the overall market moves lower.
Take high-flying Tesla Motors (TSLA 1.87%) as an example. The young electric-vehicle maker is trading at a market capitalization level that's more than half that of industry stalwart Ford Motor Company (F 0.58%), despite delivering just over 31,000 vehicles in 2014 compared to Ford's global sales of more than 6.3 million cars and trucks. Furthermore, Ford's trading at a forward price-to-earnings ratio of about 7.5, while Tesla is trading at a staggering 80 forward price-to-earnings.
While comparing Ford and Tesla is far from ideal -- because of Tesla's straight-to-consumer business model, far fewer models are on sale, with much higher average transaction prices and margins -- you can understand why 25% of Tesla's outstanding shares are sold short due to its high valuation, compared to less than 3% of Ford's.
Short-sellers were recently rewarded with a 10% drop in Tesla's stock price after a disappointing second-quarter report -- but I wouldn't short Tesla going forward.
Big-time downside
Let's be honest, sometimes the market gets it wrong -- stocks can trade at astronomical price-to-earnings ratios for years, remaining above a company's intrinsic value forever. The reason that's important is that the amount of money you can lose on an investment while short-selling is technically unlimited.
When you go long on a company's stock and are wrong, at maximum you're only out the total sum you invested, nothing more. When you borrow shares to sell short, you're required to buy those shares back at whatever price. That's a huge risk for short-sellers, regardless of the company.
But let's look at some reasons not to short Tesla specifically.
Early in the game
Here's what we know: By nearly all consumer and critical accounts, Tesla made an incredible vehicle with the Model S. A couple of years ago, Consumer Reports, widely regarded as the most influential magazine for car shoppers, handed the Model S a score of 99 out of 100, and commented that it was the best car it had ever tested.
Now, Tesla expects deliveries of the Model X to start late in the third quarter, and those of the Model 3 to start in late 2017. Those are two huge catalysts looming for investors over the next two years, which could make the stock volatile either because of positive or negative overreactions. The success and quality of the Model S would make me extremely hesitant to bet against the quality and desirability of the Model X and Model 3 -- especially at a time when transaction prices are climbing and SUV sales are booming in the U.S. market.
Honestly, Tesla's upside doesn't solely revolve around the automotive industry. Not only does the company have the potential to revolutionize the world with long-range and high-quality electric vehicles, it's developing battery technology that can store solar energy for homes and businesses. It's essentially a no-brainer for the company considering the scale of its 50 GWh Gigafactory, although the competition facing Tesla in that market is fierce.
What it all means
Here's what we know. Tesla has the potential to help revolutionize the world and reduce our dependence on fossil fuels. The cost advantage of recharging vehicle batteries over using gasoline is significant and likely here to stay, despite recent gas price declines. Furthermore, Tesla is the only automaker directly building out a network of charging stations, called SuperChargers, in an attempt to alleviate the range anxiety of buying an electric vehicle -- a huge advantage if Tesla's Model 3 is going to convince the masses an electric vehicle is a viable replacement for their gasoline-powered vehicles.
In addition to the success Tesla's Model S is enjoying in the United States, the company is continuing to improve its business model in China, which is already the world's largest automotive market. As short-selling essentially means your downside is unlimited, betting against a young company building its business around future trends seems like a terrible idea. Short-selling, in my opinion, should be reserved for betting against dinosaur business models -- such as RadioShack or Blockbuster.
Tesla's high valuation is undeniable, and for that reason I won't be starting a long position -- but I can't fathom starting a short position with a company like Tesla that has such a potentially disruptive future. If you like investing with the odds stacked against you, I'd suggest taking a trip to the nearest roulette table and placing money on red.
