Shorting Stocks: How Should You Analyze Possible Candidates?

Even a careful investor can take a bath betting that any company's shares are heading lower soon.

Motley Fool Staff
Motley Fool Staff
Mar 7, 2019 at 3:44PM

Stock traders tend to buy and sell positions fairly often. They play with hedges, time the market, study the technical charts, and if they see a slump ahead for a company, they may just sell its shares short. Investors buy great companies and keep them in their portfolios for the long haul. As a rule, that's a smarter way to go. But...what if an investor is tempted by what appears to be an obvious decliner?

That's the dilemma faced by a MarketFoolery listener in this segment of the podcast. He asks host Chris Hill and Motley Fool Asset Management's Bill Barker how a person should analyze a stock they are considering shorting. The duo discuss the few pros and many cons, and what investors should be looking for in a short.

A full transcript follows the video.

This video was recorded on March 4, 2019.

Chris Hill: E-mail from Isaac Mellon in Wisconsin. Isaac writes, "I've never shorted a stock, nor do I have the confidence in my investing knowledge to go out there and do it. I know The Motley Fool is focused on the buying and holding of great companies for the long haul, and I adhere to that guiding principle as well. However, I feel like shorting stocks could be a useful skill when deployed selectively and carefully. Do you have any recommendations on how to analyze potential shorting opportunities? The only stock I ever considered shorting was Bed Bath & Beyond. When I look out five or 10 years, I don't really see a world where Bed Bath & Beyond is successful or maybe even around. However, the same thing could probably have been said about Best Buy several years back and look where they are now. I'd love any thoughts you might have on this topic and any stocks your analysts have considered shorting or have actually shorted. Thanks."

Great email for a couple of reasons. One, because I like that Isaac is thinking about shorting selectively and carefully. That's certainly how I view it. Like Isaac, I've never shorted a stock before. And I like that he found two relevant examples, both in the same industry. He's absolutely right. There was a point in time when there were people out there saying, "Man, Best Buy, that thing is doomed. That thing is going down." Hubert Joly came in, turned the company around. You probably took a bath if you shorted Best Buy at that point in time. Bed Bath & Beyond, that's another story.

Bill Barker: That is another story. We've kicked in the teeth of Bed Bath & Beyond on a quarterly basis. Whenever I've been around look at their quarterly reports, they have been ones which would delight bears, delight people who are short, for the reasons that your listener/emailer has identified. Why is this thing still around? Do we need it? I think the theses for shorting a stock need to rely on a long-term trouble. There have been people who have successfully timed, "Oh, this company is good, but it's just way too expensive." And there have been people who have lost all their money on the same type of thing. As you will hear, the market can stay irrational longer than you can stay liquid when you're right about the long-term but wrong about what can happen with a stock.

Now, Bed Bath & Beyond is not going to double or triple or quadruple on you through investor enthusiasm, so I think that that's a much safer play. What they've been doing, buying back stock, closing down some stores, the same mall-based kind of story that we've just discussed. I like that as a thesis. I don't know where the stock is today. Lower than it has been in the past.

You've never shorted anything?

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Hill: I've never shorted anything. I have done this long enough to know -- and this ties into something you just said -- that if I'm ever going to short a stock, it's not going to be a situation where I think my valuation skills are better and smarter than everyone else's. You're right, it really does seem like the people who get burned on shorting are the people who look at a stock at a high valuation and say, "This is just crazy. Why is there this enthusiasm?" To your point, Bed Bath & Beyond is a business that does not have a lot of enthusiasm around it. I think, all things being equal, for your first time shorting a stock, you're better off going with the proverbial "this is a troubled business within a challenged industry."

Barker: Yeah, and I'd want to see management that is taking unnecessary risks. With Bed Bath & Beyond, I don't have the data in front of me because my computer has died. Otherwise I would just pretend like I knew that kind of thing off the top of my head by reading something online.

But, what are the costs of shorting? Well, the dividends that you have to pay when the company pays them when you're short the stock. And, say Bed Bath & Beyond agrees, "Our future doesn't look so good. What we'll do is try to maximize the profits from today. We won't go out building new stores, getting into lots of long-term leases and malls. We'll just buy back our shares with the money they're making." They're still making profits there. "And, we'll pay a dividend." Well, then, if you're short the stock, you're going to be paying that dividend, and the stock price won't really be going down that much if the company is using its dying breaths to keep buying back shares.

Ultimately, if it's doomed, the stock will go to zero. But in the meantime, you may be paying a lot out in dividends from the short side.

Hill: Isaac concludes his email by writing, "Totally unrelated, I'm in medical school and we just finished up our gastrointestinal pathophysiology course. The attached slide was in one of our lectures. Since our professor did not cite the source, I can only assume he's been listening to MarketFoolery and learning about the science of coffee as a miracle beverage. Thank you for educating the masses."

He includes this slide. Frankly, it's a lot of medical stuff, which I guess when, you're in medical school, that's probably just as well.

Barker: Fair enough.

Hill: A lot of terms that frankly don't resonate with me. But basically, if I'm reading this correctly, and I like to think I am, one of the treatments of viral hepatitis? Coffee. There you go! Studies suggest coffee consumption is inversely related to liver enzyme cirrhosis, etc.

Well, as Isaac said, and he's in medical school -- you're not in medical school, I'm not in medical school. Here's Isaac, he's in medical school. And he used the term "miracle beverage."

Barker: Oh, yeah. As have others. Miracle is a long way to go, but how else can you explain all the things that coffee does?

Hill: Have you seen this coffee brand? The brand is Super Coffee. I've seen it in a grocery store nearby.

Barker: And yet, is not all coffee super?

Hill: Right, that was my thinking. I was like, that seems redundant, to call it Super Coffee.

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