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Sometimes Your Smartest Investing Move Is to Remain on the Sidelines

By Sean Williams - Apr 6, 2017 at 7:09AM

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You have to be willing to examine all aspects of an investment before taking the plunge.

There are literally thousands of stocks that investors can choose to invest in or bet against. Weeding through them all can be quite the chore, but the presumed reward is that you'll find what you believe are a handful of surefire gems that are expected to move significantly up or down in value. Once you find these "gems," you can place your bets accordingly.

However, sometimes it's just not that easy. From time to time, Wall Street and Main Street see eye-to-eye, and your best move winds up being to remain on the sidelines. Allow me to explain from my own personal experience.

An investor reading a financial newspaper and plotting their next stock purchase.

Image source: Getty Images.

A valuable lesson in patience and return potential

Last summer, my mind was fully set on short-selling shares (i.e., betting they go down) of drugmaker MannKind (NASDAQ: MNKD). My investment thesis was pretty straightforward: MannKind was eventually going to seek bankruptcy protection.

MannKind has just one Food and Drug Administration-approved therapy, an inhalable type 1 and type 2 diabetes drug known as Afrezza. On paper Afrezza looked like a winner. It was fast-acting, it metabolized through the body more quickly than traditional insulin, and it was exceptionally convenient since there were no needles involved. The company also wound up licensing the drug out to Sanofi (SNY 2.19%) in 2014, netting much needed upfront capital and help on the expenses front.

But MannKind's dreams were quickly dashed. Afrezza struggled to get to just $2 million in quarterly sales, and Sanofi soon backed out of its licensing deal after it was deemed to be "not economically viable." Without a seasoned sales partner, MannKind was left to fend for itself. All the while, the company's avenues to new capital were dwindling. It dually listed its shares in Tel Aviv, but it fell well short of the capital it was looking to raise with such a move.

Thus, when an apparent short-covering rally sent MannKind shares over $1.50 last year, yours truly was looking to pounce and bet against the stock via a short-sale.

A frustrated stock trader in front of his laptop.

Image source: Getty Images.

However, there was a problem. Because MannKind's stock was so volatile, and so many other investors had already borrowed short shares against the company, MannKind had become a "hard-to-borrow" security according to my online brokerage. The hard-to-borrow designation allowed the brokerage to charge an added borrowing rate on top of the expected margin rate that an investor pays when short-selling a stock. As you can see from the screenshot image in this article, had I continued with my transaction and short-sold MannKind stock, I would have been paying a 99% annual interest rate. That's not a typo... I really said ninety-nine percent!

In this instance, even though I felt exceptionally strong about MannKind's stock heading lower, it made more sense to remain on the sidelines and not go through with the short-sale.

The smartest move is sometimes no move at all

And this is not an isolated incident. There are other companies that appear substantially overvalued where it just doesn't make sense to enter a short-sale position.

For example, Sears Holdings (SHLDQ) has been actively attracting short-sellers in recent months. Sears has been downsizing both its Sears and Kmart locations in an effort to save money, and it's been parting ways with a couple of its core brands. In January, Sears announced that it was divesting its Craftsman brand to Stanley Black & Decker (SWK 1.59%), which will allow Stanley Black & Decker to get the Craftsman brand into far more department stores than just Sears.

A businessman pressing the "bankruptcy" key on a digital board.

Image source: Getty Images.

However, parting ways with its core brands and paring its underperforming locations isn't exactly a long-term strategy. According to Fitch Ratings, Sears is expected to burn through $1.8 billion in cash in 2017, and this includes the expected savings of $250 million from store closures. Even with cash from its Craftsman deal, a debt restructuring, and a $500 million real estate loan, Sears is considered a going concern and may not have enough cash to survive the year.

With this in mind, I thought that shorting shares of Sears, or better yet, buying leap put options on Sears, could be an intriguing strategy given its struggles. In essence, I foresaw the strong possibility of bankruptcy, but have no clue when exactly it'll happen over the next year and change.

But I was a bit surprised at how the Jan. 2019 put options responded to the latest rally over the past week and the change in Sears' shares. Despite a better than 50% increase in its valuation (around a $4 per share increase from the mid-$7s to $11.76), the $8 strike for Jan. 2019 has fallen from just $4.50 to $4.15. In other words, Sears shares would have to fall by 67% to $3.85 just for these leap put options to be intrinsically breakeven. That was more than enough reason for me to abandon my idea of betting against Sears, even if it seems like a really good shot to see its shares decline in value.

Sometimes the smartest move you can make as an investor is to not make a move at all and stick to the sidelines.

Sean Williams has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Sears Holdings Corporation Stock Quote
Sears Holdings Corporation
SHLDQ
Sanofi Stock Quote
Sanofi
SNY
$44.37 (2.19%) $0.95
Stanley Black & Decker, Inc. Stock Quote
Stanley Black & Decker, Inc.
SWK
$99.86 (1.59%) $1.56

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