6 Things I Learned About Betting Bearishly

Short-sellers often get a bad rap in the investing world. When the market is up, they're chastised for holding back the rally. When the market is down, they're reviled for keeping it "artificially low." And when the majority of long-term investors are hurting, successful short-sellers profit most.

While short-selling can pay off, the strategy is risky. Here's what I've learned since I started practicing on paper in 2006.

The good
It's always fun to successfully bet against a company and have your thesis proven correct. Here are three of my best-performing bets:

*Still active.

The lessons I learned from this group were:

1. Don't be afraid to jump on a sinking ship (New Century). When I initiated my bearish position on New Century Financial, it was mired in subprime mortgage loans, was being sued for misleading investors, and had already fallen 90% from its 52-week high. Sure, there was the risk of a sharp rebound. But normally, when there's one case of management dishonesty, there are more that have yet to be uncovered. That, combined with the collapsing housing market, meant that New Century probably had more room to fall.

2. Know a fad when you see one (Heelys): Combine roller skates with gym shoes, and you have Heelys. Back in 2006-2007, they were all the rage with the fifteen-and-under crowd who used them to slide down grocery aisles, hallways, and malls with the greatest of ease -- rarely wearing a helmet or other protection. This led to increasing safety concerns among doctors. With protective parents growing concerned, it was only a matter of time before sales of the footwear began to slow -- to the tune of 61% between 2007 and 2008.

3. Realizing when something's a bit fishy (Corinthian Colleges). I became wary of for-profit education company Corinthian Colleges in 2008, when Sallie Mae (the government-sponsored student loan provider) announced it would no longer issue subprime student loans. Corinthian Colleges, whose students typically rely on subprime loans to pay for tuition, responded by lending and backing $100 million of subprime debt to its students to make up the difference. If this wasn't reason enough for concern, in late 2007, federal investigators raided three of Corinthian's campuses on allegations of waste, fraud, and abuse of federal education dollars. It took some time for this thesis to play out, but sticking with my gut eventually paid off. Other for-profit colleges like Apollo Group (Nasdaq: APOL) and Strayer Education have recently come under closer scrutiny regarding the use of federal financial aid.

The ugly
The three lessons learned from my successful calls are worth remembering. But the lessons learned from my worst short calls are immensely more valuable, because they can potentially help you avoid massive losses.

1. Know when to take a gain / say "uncle" (Talbots). When I initiated my bearish position on Talbots in November 2008, no one wanted to go near retail stocks, as investors braced for what the new consumer reality might look like after the credit crisis. Betting with the crowd should have been reason No. 1 not to go bearish, but it actually worked out for a month or so -- Talbots fell to a low of $1.45 in early December, which would have netted me a 50% gain. Did I take the gain? No, I got greedy. Within another few months, Talbots was back up to $4 a share. Once again, I got greedy and waited for another big dip ... but that never happened. In fact, the opposite occurred, and I held on while I lost 100%, 200%, and eventually 300%. Bottom line: Know when to say when.

2. Avoid stocks with a cult following (Abercrombie & Fitch). Similar to my timing with Talbots, I bet against Abercrombie when investors were down on retail, but I had a good hunch that Abercrombie's high-priced clothing lineup would be in trouble during the recession. Adding fuel to my thesis was Abercrombie's seemingly stubborn refusal to discount in order to protect the longer-term value of its "aspirational" brand. Even though margins got pinched in the following quarters, the stock rose sharply as analysts latched on to its international expansion plans and ignored the struggling domestic locations.

3. Don't go bearish on valuation alone (Amazon.com and Buffalo Wild Wings). High-quality companies will always be tough shorts, and my bets against Amazon.com and Buffalo Wild Wings were no exception. When I bet against Buffalo Wild Wings in November 2008, for example, it was trading for 17 times earnings, at a time when consumers appeared to be on the ropes. Amazon.com traded for 50 times trailing earnings in May 2009, when I turned bearish on it. In both cases, I was too focused on the multiple, and not focused enough on the underlying health of the businesses. Buffalo Wild Wings and Amazon each have strong balance sheets, and analysts expect them to grow long-term earnings at 22% and 25%, respectively.

Foolish bottom line
Fortunately, I learned these six shorting lessons without risking my capital -- only my pride. Going forward, however, with these lessons fresh in my mind, I'm much more confident putting real money behind my convictions.

If you'd like more shorting lessons, we'll send you a new report, "5 Red Flags -- How to Find the Big Short," by John Del Vecchio, CFA, a leading forensic accountant who has made a good deal of money identifying companies with low-quality earnings. Simply enter your name in the box below -- the report is free.