The day after the 4th of July, Carvana (CVNA -0.36%) stock popped like a firecracker, running up 25% on no news. Does this mean its sell-off has hit bottom and the stock will continue to surge higher? Not necessarily. I'm bullish on Carvana, but in the short term, the stock could go anywhere. It could drop another 50%, or it could double.
This is true for many growth stocks, but especially so for Carvana because it's a favorite target of short-sellers -- in other words, investors who are betting on the stock to go down. I think shorting any stock is dangerous, because when that stock goes up, you could suffer steep losses for reasons I'll explain shortly. And shorting a former highflier can be catastrophic. Here's why shorting Carvana is a really bad idea.
1. Debt makes you vulnerable
The way a short sale is structured, you borrow shares from your brokerage at today's price with the obligation to buy them later, paying what the shares cost at that time. If the stock costs less when you close your short position than it did when you opened it, congratulations -- you made a profit on your short. But if the stock goes up, so does the amount you're obligated to pay later.
Unlike buying shares of a stock, shorting a stock means you're actually signing an I.O.U. to your brokerage. You're taking on a form of debt -- and your brokerage needs to make sure you're good for it. If the stock you're shorting pops higher, and the brokerage needs proof you can cover your debt, you will receive a margin call. That means you have to add cash to keep your short active. If you fail to provide the cash, the brokerage will often close the short (i.e., buy the stock) even if you don't want to. This can have a ripple effect, spiking the price higher and causing even more margin calls at other brokerages. This is what's known as the dreaded short squeeze.
I'll stop before it gets too complicated. Just remember this: Every bear who's short Carvana is a future buyer of the stock. The more the shorts pile up, the more future buyers we have.
Almost 30% of Carvana's public float (that is, the shares on the market) is sold short. That's high.
2. You're on the wrong side of the miracle of compound returns
The most amazing thing about the stock market is that the math is on your side. Your downside is limited. If you avoid margin debt, the most you can lose is 100% of your investment in a stock. If you invest $1,000, you can lose $1,000. But your upside is infinite. That's how people get rich in the stock market. You might have some losers that drop 50%, 75%, or even 100%, but that's a hard stop. Meanwhile, when you're right, your winners can go up 1,000%, 10,000%, or even higher than that. The stock market rewards patient, long-term investors, and sometimes by a lot.
Carvana might be a $1 trillion company one day, or it might go belly up. But the bulls have an infinite upside and a finite downside.
A short has exactly the opposite scenario -- finite gains and infinite losses. That's why brokerages are quick to make margin calls if the stock starts to charge higher. They're not going to fund your downside forever -- it's too dangerous.
3. The history of Carvana shorts is ugly
If you think people are bearish on Carvana now, you should have seen what the market was like back in 2018. People were lining up around the block to short Carvana -- 120% of the company's float was sold short. At the time, the stock was trading at about $20 a share. Those early short positions were obliterated over the next couple of years, as the stock spiked to $239 by the end of 2020.
4. Shorting a highflier because of valuation is the worst kind of short
I don't short anything, but if I were going to short a stock, it would be a horribly run company that's heading for nonexistence. Technology shifts, and companies in the old world can die an ugly death. Ask Smith Corona or Kodak what happens when technology changes the world.
What's dangerous is to short a Rule Breaker like Amazon, for example. People did that back in the day because its valuation seemed out of whack. Amazon's revenue growth was sky-high, but the company was unprofitable for many years, and a lot of people thought Amazon was heading for bankruptcy.
Amazon had a lot of shorts, and its stock once dropped 90%.
In the short term, some of those shorts might have made money. (Although you should notice all those peaks in this ugly bear chart -- those short-term spikes can drive shorts from their positions).
But of course, the real mistake is to fixate on valuation with a young company that's growing quickly and miss its potential upside. Amazon bulls were right on the merits. Whatever profits are made in a short-term valuation call are tiny anthills compared to the giant gains to be made in owning a mighty business over decades.
Will Carvana pull off an Amazon-like transformation of the used car industry? I think so.
My investment thesis is that used auto sales will shift to the internet. As the company leading this transformation, Carvana is my favorite pick in this long-term trend. Carvana is winning the race for the online auto market now. If it's the ultimate winner, like I think it will be, the stock will be incredibly valuable over the next decade.
