FOOL ON THE HILL
Good Time to Short Stocks?

A bear market can be a good environment for short sellers who are betting that stocks will go down, but Whitney Tilson will pass on the opportunity. In this article, he explains his reasons why.

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By Whitney Tilson
January 2, 2001

Last year -- especially last quarter -- was a marvelous time for those who short stocks (e.g., bet on and profit from a stock's decline). After a number of years in which the euphoric, momentum-driven bull market crushed most short sellers, the nonexistent business models and preposterous valuations of many companies finally caught up with their stocks. Declines of 90% or more were commonplace. Regrettably, as is usually the case when bubbles burst, it has been small investors who have suffered the most. (Rest assured that venture capitalists and those on Wall Street who sold so much garbage to the general public did very well last year.)

With so much uncertainty about the market's future, perhaps you've thought of shorting stocks so that you could make money (or at least mitigate your losses) should the market weakness continue. It's an appealing idea, but ultimately I believe a flawed one for almost all investors -- myself included.

Background on shorting stocks
Shorting a stock means betting that it will decline. To do so, you (or your broker) borrows a stock and immediately sells it. You keep the cash, but must eventually return the stock you borrowed to the lender. Your hope is that the stock will decline such that you can buy the stock back in the market at a lower price, return the shares to the lender, and pocket the profits.

For example, let's say you short 1,000 shares of a stock trading at $10. You pocket the $10,000. Then the stock falls to $6 and you decide to cover your short, so you buy the 1,000 shares back for $6,000 and keep a $4,000 profit. Note that since no stock can fall below zero, your upside is limited to the amount that you shorted.

The potential peril occurs when a stock you've shorted rises. Now, you're faced with coming up with extra capital to buy back the stock and cover the short. If the stock rises too much, your broker can force you to cover. This means that you -- and likely other shorts -- have to buy the stock in the open market, which can cause the stock to rise further. This is called a "short squeeze," and it isn't pretty.

A short's worst nightmare
A friend of mine who runs an investment fund told me about an analyst who presented a compelling argument for shorting a particular technology stock. This company was growing rapidly, but so were its losses. It had many dissatisfied customers and was engaged in questionable accounting techniques to make its losses appear lower than they were (it later abandoned those techniques and restated earnings). Capping this story, the stock was preposterously overvalued by any traditional valuation metric in part due to its status as a favorite of day traders, momentum investors, and denizens of chat rooms.

What a great short, right? The stock was America Online (NYSE: AOL) -- a little more than four years ago, when it was at a split-adjusted price of less than $1.50 per share.

Myths of short selling
Some people view short selling as something akin to flag burning. It's un-American to hope that a company stumbles and its stock plunges, right? Rubbish! Just as a healthy legal system needs both defense attorneys and prosecutors, healthy financial markets need people who will look at companies in a skeptical light, given that accountants, Wall Street and the companies themselves have such strong incentives to spin a positive story. Short-sellers -- and the handful of courageous journalists who cover their pans -- are a blessing to savvy investors, even those who only invest on the long side. By reading and understanding the shorts' arguments, I have avoided or sold stocks that have subsequently declined significantly.

Arguments against short selling
I have studied the art of shorting and, in the course of researching hundreds of companies over time, have identified at various times a number of stocks that I thought would be good short candidates. However, I have never shorted a stock and -- for now anyway -- have no intention of doing so because shorting is harder and more dangerous than buying long positions for a number of reasons:

The long-term upward trend of the market works against you.

Gains are taxed at the highest, short-term rate.

You not only have to be right about the stock, but also about the timing. If a stock rises significantly, you might choose to -- or be forced to -- cover (and thus lose money), even if it subsequently crashes.

It's a short-term, high-stress, trading-oriented style of investing that requires constant oversight.

It generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.

Mistakes hurt your portfolio more as they compound. If you make a mistake with a long position, it becomes a smaller percentage of your portfolio as it drops. A mistaken short, however, grows in importance as it appreciates.

Most importantly, your upside is capped and your downside is unlimited -- precisely the opposite of long positions. When shorting stocks, you could be right 80% of the time, but the losses from the 20% of the time that you're wrong could exceed the accumulated profits. Worse yet, a once-a-century storm might wipe you out entirely. I'm not willing to take even a 1% annual risk of such an event. Over 50 years -- roughly how long I view my investment horizon -- that tiny risk translates into a 39.5% chance of the freak event occurring.

The final, clinching argument for me is that I am time constrained -- who isn't? -- which means that every minute that I spend looking for and analyzing short opportunities is a minute that I'm not spending trying to find my holy grail: a small handful of stocks that will appreciate 5 to10 times over the next 10 years (that's a compound annual growth rate of 17% to 26%).

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, click here.