Shorting stocks is risky business, but it can provide rich rewards if timed appropriately. The process -- which represents a bet that a stock will fall rather than rise -- is done by borrowing shares from a brokerage and then selling them on the open market. If the stock falls, the short seller can repurchase the borrowed shares at a lower price, return them to the brokerage, and keep the profits.
Tech stocks, with their often sky-high valuations, present ripe targets for shorts. Internet stocks in particular have attracted some inflated prices, and shorts have come out in force against stocks like Yelp, which has 22% of its shares sold short, and Groupon, at 16%.
The inherent risk of shorting comes because there's no limit to the short seller's losses. Unlike buying a stock -- where an investor can only lose the money that they've spent -- the loss potential from shorting is theoretically infinite because the investor is on the hook for all the gains if the stock goes up.
Tech stocks, which tend to be more volatile than the broader market and have explosive potential, are especially risky for this reason. They can jump in a heartbeat -- often on little news.
Jeremy Bowman (Amazon.com): On the surface, Amazon.com may look like the ideal short play. After all, this is a company worth $200 billion with no profit to speak of. Conventional valuation measures such as the P/E ratio lose their meaning when applied to the stock.
Even on a forward-looking basis, the stock has a gargantuan P/E of 170 -- and that's with analysts likely overestimating the company's 2016 earnings, as they have for several years running.
Nonetheless, Amazon's stock keeps moving higher as sales continue to grow around 20% annually. Investors seem unconcerned about the lack of profits and focus instead on the company's build-out of competitive advantages surrounding its leading position in e-commerce. The stock hit an all-time high earlier this year, and with the exception of last year -- when it fell 25% -- Amazon stock hasn't faced a sustained down period since the tech bubble burst in 2000.
However, the biggest reason to avoid shorting Amazon is because the company, despite its claims of focusing on the long term, still keeps an eye on profit. CEO Jeff Bezos has admitted that the company does like to "check in" on its ability to make a profit from time to time.
This means that if losses begin piling up, Amazon is likely to turn a couple of screws to cut losses and deliver a profit once again. Therefore, any swoon in the stock will likely be reversed, leaving the shorts burned.
Bob Ciura (Netflix): I wouldn't short Netflix. Shares of the Internet streaming media company are up an astounding 180% in the past two years.
Many investors think Netflix is a fantastic short idea because of its bloated valuation. After all, at its recent $623 closing price, Netflix is valued at a whopping 162 times trailing 12-month earnings.
Some might counter that Netflix is growing fast enough to grow into this multiple. But Netflix is still valued for 180 times forward earnings, as its profit is expected to dip slightly in the near-term due to the money it's investing in new markets.
However, it's important to remember that growth stocks don't often trade based on valuation alone. After all, by traditional valuation metrics such as the P/E ratio, Netflix would have always looked extremely overvalued. Consider that Netflix earned $0.29 per share in 2012. Even at its lowest stock price that year -- roughly $54 per share -- the stock still traded for 186 times EPS. That didn't stop the stock price from soaring more than ten-fold since then.
The bottom line is that investors shouldn't short a high-growth company just because it has a high P/E. That's a great way to get burned, and no stock is a better example of this than Netflix.
Tim Brugger (Microsoft): It's easy to forget now, but it wasn't that long ago that Microsoft shareholders had little to celebrate. After years of its stock price being mired in a slump, Microsoft has just recently begun to reward investors with not only its sound 2.6% dividend yield, but a stock price jump of more than 18% in the past year.
Why does Microsoft's performance put it on the list of stocks to never short? Because even before the past year's nice share price run-up, Microsoft's stock didn't drop off a proverbial cliff -- a short investor's dream scenario -- it simply meandered. And if recent results are any indication -- and they are -- the opportunity to profit by shorting Microsoft has become even more remote.
It's taken a while, but investors seem to have finally started to measure Microsoft by results in its "mobile-first, cloud-first" efforts, rather than simply bemoaning declining PC-related sales. In the "dark days," Microsoft's double-digit decline in Windows-related revenue last quarter would have been cause for concern. Now? Another triple-digit jump in cloud sales in fiscal 2015's Q3 -- bringing the annual run-rate to $6.3 billion -- resulted in a 10% pop in Microsoft's share price.
You can bet that with Satya Nadella at the helm, Microsoft's transition to the cloud is in full swing. Furthermore, with one of the tech industry's best dividend yields, Microsoft stock isn't about to nosedive anytime soon. Which is the last thing a short wants to hear.
Bob Ciura owns shares of Apple. Jeremy Bowman owns shares of Apple and Netflix. Tim Brugger has no position in any stocks mentioned. The Motley Fool recommends Amazon.com, Apple, Netflix, and Yelp. The Motley Fool owns shares of Amazon.com, Apple, and Netflix. 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.