Turn Your Worst Stock Ideas into Profits

Most investors rely on buying great-performing stocks for their success. In a few rare cases, though, you'll find investors who can make money not only by finding strong stocks with big profit potential but also by picking other stocks that are destined to perform badly.

The long and the short of it
Most mutual funds and ETFs are designed to make money only by buying stocks that go up in value over time. Long-short funds, however, also try to create profits by betting against companies they believe will see substantial share price declines. By selling shares short, these funds make money when their short candidates lose value.

At first, this may sound like a strategy that's doomed to underperform regular funds. After all, a rising market often will pull the majority of stocks higher, so money made on long positions will be offset by losses on shorts and vice versa. But if managers pick wisely, then they can score the double victory of seeing their long positions rise while their shorts fall.

One mutual fund in particular has done an extraordinary job of producing gains from this strategy for more than a decade. The Robeco BP Long/Short Equity Fund (BPLEX) has an impressive track record that could show you how to implement a similar strategy.

Putting it together
The Robeco long-short fund has put up amazing numbers recently. Last year, the fund posted a dramatic 81% gain, reversing its 21% loss in 2008.

The fund's strategy is relatively straightforward. On the long side, the fund likes to buy fundamentally strong companies at reasonable valuations where there's a catalyst for future improvement. For short candidates, the fund seeks out bad business models that are enjoying temporary profits, or companies that don't have anything but a concept for generating revenue and earnings.

In 2009, fund manager Robert Jones attributed much of his strong performance to a timely overweighting of financial and technology stocks, as well as astute picking among health-care companies. The fund identified bank giant JPMorgan Chase (NYSE: JPM  ) and reinsurance specialist Maiden Holdings (Nasdaq: MHLD  ) as good values, and both recovered strongly from their 2009 lows to contribute to big gains for the fund. Medical equipment maker Varian Medical (NYSE: VAR  ) and medical transcription company MedQuist (Nasdaq: MEDQ  ) escaped some of the carnage that health-care reform has had on higher-profile companies.

Right now, the Robeco fund has maintained its focus on financials. Although pickings on the short side have been fairly scarce, the fund thinks gun-maker Sturm Ruger (NYSE: RGR  ) , which has doubled in price since early 2008 on increased demand for firearms, will slide once that unsustainable demand dries up. Consumer research company Arbitron (NYSE: ARB  ) also makes the short list, which still faces a substantial debt load even after reducing it substantially over the past year. Finally, German tech company Aixtron (Nasdaq: AIXG  ) is banking on a boom in the LED market, but given that it currently trades at 33 times earnings, the company needs that to happen sooner than later to justify its valuation.

Get the best of both worlds
With flexibility that most funds don't have, long-short funds keep all their options open. Rather than having to pass up overpriced stocks that have little potential for future profit, they can capitalize on those stocks to profit when they fall. Yet their emphasis on long positions -- the Robeco fund, for instance, is 82% net long on stocks -- gives you the stock exposure you want for a smart asset allocation strategy.

Whether you trust your money to a fund manager like Robeco or decide to implement the strategy on your own, combining well-vetted stocks that will rise in value with some carefully selected short positions in overpriced stocks can help you enhance your overall gains. In an environment in which it can be hard to find great stocks, having a way to make money from stocks you think will do badly will give you a big edge.

Alyce Lomax has some short candidates with stocks you should run away from right now.

Fool contributor Dan Caplinger always tries to make lemonade from lemons. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't sell you short.


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