You Can't Win in This Market

To look at my email inbox is to wonder whether:

(a) My friends are all exiled Nigerian bankers with loads of excess cash.
(b) I'm on more medication than Lindsay Lohan.
(c) Hedge funds and short-sellers are out to destroy me.

Since neither "a" nor "b" have much to do with investing -- unless, that is, you're betting on the burgeoning futures market built around the odds of Lohan landing in jail or rehab again -- let's focus on "c." Should I be paranoid about hedge funds and short-sellers? A reader thinks so. Here's what he wrote to me recently:

"Please help us smaller investors to fight against the naked short selling and stock manipulations in our market. Small investors have no chance to win at all. (Emphasis added.)"

Really? I beg to differ:

Company

52-Week Return

Short Interest

Overstock.com (NASDAQ:OSTK)

46.5%

31.2%

SunPower (NASDAQ:SPWR)

229.7%

8.6%

TASER (NASDAQ:TASR)

86.2%

26.8%

Sources: Nasdaq Reg SHO list, Yahoo! Finance.

Yes, Virginia, there is a Santa Claus ... and his name is Mr. Market
Each one of these stocks has spent months, and in some cases years, on the Nasdaq's Reg SHO list, which identifies firms commonly thought to be the subject of short attacks. Especially naked short attacks. Yet owning any one of them over the past year would have helped you to crush the market in grand fashion.

Now, does that mean you should buy every stock on the Reg SHO list? Certainly not. There are some pretty bad businesses on that list. Overstock, though improving, may still be one, thanks to a long and sordid history of capital destruction.

My point is simply this: While it's true that prices can't move up when there are more sellers than buyers, given time, excellent businesses always eventually draw more buyers than sellers.

And that spells opportunity for you, the belled-cap small investor who doth call himself Fool.

Here's why. Short sellers generally have a very short timeline. After all, if you continue to hold a short as a stock rises, your losses can deepen substantially.

Thus, when they err by shorting companies that continue to post outstanding fundamentals, they create temporary price depressions that enable massive long-term returns. Behold:

Company

52-Week Return

Current Shares Short

Prior Shares Short

Atheros (NASDAQ:ATHR)

31.0%

7.535 mil

5.869 mil

Ctrip.com (NASDAQ:CTRP)

123.7%

1.783 mil

1.616 mil

Google (NASDAQ:GOOG)

46.4%

5.625 mil

4.979 mil

Sources: shortsqueeze.com, Yahoo! Finance.

Still not convinced? Check out the long-term returns for Atheros, Ctrip.com, and Google vs. the S&P 500. Because they've traded at what look like premium valuations, all three have a history of being targeted by short-sellers.

Small caps bite back
Therein lies the single greatest advantage of the small investor: time. By staying invested longer than others will -- certainly longer than the shorts will -- you can profit from those looking only to make a quick buck. Three-to-five years is an ideal time frame for Tom Gardner and Bill Mann, who together co-host Motley Fool Hidden Gems, the Fool's market-beating small-cap service.

Color me unsurprised. It's no accident that the majority of the stocks we've presented here are small caps. Such firms are rarely followed as closely as their larger brethren and, thus, are more likely to be undervalued or unfairly shorted.

And remember: 10 small caps went on to become the 10 best stocks of the past decade. Via Hidden Gems, Tom and Bill are hunting for the next 10.

So let the Chicken Littles cluck all they want, Fool. You, the small investor, have no chance in this market? Poppycock.

Atheros Communications and Ctrip.com are Hidden Gems recommendations. Get access to the entire portfolio of stocks that Tom and Bill are recommending now with a 30-day free trial. There's no obligation to subscribe.

Fool contributor Tim Beyers didn't own shares in any of the stocks mentioned in this article at the time of publication. TASER is a Rule Breakers recommendation. The Motley Fool's disclosure policy was never small-time. It just went big-time.


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  • Report this Comment On December 08, 2007, at 7:04 AM, BigB2000 wrote:

    I'll make this short. Shorting is a way for creating an efficient market. However, you did not address the problem of naked shorting where non-existing shares are created out of thin air. A legal shorter takes on risk when they borrow shares in order to short them. Naked shorters with the aid of the SEC and Clearing Houses bypass this risk so that they can leverage their short position.

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