When upscale burger chain Shake Shack (NYSE:SHAK) went public at $21 per share at the end of January, the market displayed a ravenous appetite for the shares, pushing the price up 119% to a $45.90 closing price on their first day of trading, for a cholesterol-rich valuation of 16 times trailing-12-month sales. With the stock close to its Jan. 30 closing price, we asked three Fool.com contributors why they wouldn't short Shake Shack (i.e., borrow shares to sell them with the expectation of being able to buy them back later at a lower price and pocket the difference). Investors short a stock when they expect the price to fall.
Alex Dumortier: When Shake Shack went public, I wrote that investors ought to avoid the stock due to its valuation. However, there is a gap between identifying an overvalued stock and identifying an ideal short candidate. Valuation alone is never a sufficient reason to go short, as an overvalued stock can easily become a dramatically overvalued stock.
Even if it is overvalued, shorting the stock of an attractive business -- which Shake Shack appears to be -- is an even riskier proposition, as you can expect the intrinsic value to increase over time, thereby closing the gap with the stock price.
Sure, the stock was down as much as 10% in early trading Thursday, as the market digested the company's first earnings report as a public company, which came out Wednesday, but trying to handicap a single quarter's earnings is extremely difficult. Certainly, it's very easy for me to imagine an alternative scenario in which yesterday's earnings report was well-received and the stock gained 10% or even 20%.
For individual investors, who have limited time and resources, the best thing they can do when they spot an overvalued stock is simply to make a note of it and move on to the next issue. Trying to beat the market on the long side is challenging enough as it is -- no need to look for the added challenges associated with being short.
Dan Caplinger: Selling any stock short carries a lot of risk, but companies that have just gone public are especially dangerous as short candidates. One reason why that's the case is that newly public companies often have a very small amount of their total outstanding shares available for trading on the market, and that can cause situations in which stock supply and demand dynamics outweigh the long-term fundamentals of a business.
For instance, Shake Shack has about 11.3 million shares outstanding, but right now, it only has 5.52 million of those shares available to investors through its public float. With less than half of its total shares available to investors, and 12.6% of those publicly available shares already sold short as of mid-February, Shake Shack short-sellers are vulnerable to short squeezes from investors aggressively seeking to bid up shares. If a short squeeze occurs, you might have to sell in order to prevent losses from wiping you out -- only to be proven right in the long run when the stock eventually drops. Shake Shack does look expensive at current levels, but until the company has most of its shares available after its lockup provision expires, it's too dangerous a short for any but the most risk-tolerant investor.
Andrés Cardenal: Shake Shack stock is as hot as it gets, and valuation ratios such as price to earnings and price to sales show that the stock is demandingly priced. With this in mind, I can easily understand why some investors may prefer to stay away from Shake Shack at current prices.
However, an aggressive valuation is hardly a solid enough reason to justify a short position in a company. Even if the stock is too expensive, Shake Shack is still a strong business with abundant potential for growth, and betting against that kind of company could be a very expensive mistake.
Shake Shack operates in the fine-casual restaurant category, which combines the ease and convenience of fast-casual concepts with higher quality standards and superior ingredients. The company's signature items are its all-natural, hormone and antibiotic-free burgers, hot dogs, crinkle-cut fries, shakes, and frozen custard.
These products resonate remarkably well among consumers, systemwide sales increased from $19 million in 2010 to a much larger $140 million in 2013, according to Shake Shack's prospectus. Also, management believes it still has enormous room for growth; the company estimates that it can increase its domestic store base from 31 restaurants to nearly 450 in the long term.
Shake Shack is an expensive stock, but the shorts could be in for a lot of pain if the company can grow into its valuation over the coming years.
Alex Dumortier, CFA has no position in any stocks mentioned. Andrés Cardenal has no position in any stocks mentioned. Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.