Shorting is hard work, relying as it does on the tricky business of near-term valuation work, not to mention the virtually impossible business of timing. Get in at the wrong price -- or fail to get out at the right time -- and you'll be in a world of hurt. The same can also be true on the long side of the ledger, of course. But if you're a patient investor (and if your initial investment thesis continues to hold water), there's a strong probability of success. Not for nothing is Warren Buffett's favorite holding period "forever."
And at worst, moreover, when you go long, you'll only ever lose the amount of the investment you've plunked down. With shorting, the decline could be bottomless, if the stock in which you've (anti) invested makes like Buzz Lightyear, and takes off to infinity -- and beyond.
A bottomless pit
Those dangers notwithstanding, I'm not an anti-shorting zealot at all. The practice introduces an additional layer of market efficiency, and while I'm no efficient-markets purest, either, any technique that can add rationality to an increasingly emotional stock market has to be a good thing, right?
Particularly if it helps the market identify a price for a stock that's closer to valuation reality than, say, Fantasy Island. So rather than thinking of those pesky shorters as nattering nabobs of negativism (to borrow William Safire's Nixon-era coinage), think of them as investors tending to the capitalist equivalent of civic duty: pointing out where a stock's price is wrong -- and putting their money where their mouths are, to boot.
The right profile
So what do short candidates look like?
Good question. Distressed concerns like recent pink-sheeter Circuit City (CCTYQ) provide one model: struggling retailers in an industry with a downward pricing trajectory that follows a commodity-like trend line. Circuit City's woes, moreover, predated our economy's current malaise; it hemorrhaged cash in fiscal years 2003 and 2005. Add a competitive landscape featuring a nimble (and far more financially sound) rival like Best Buy (NYSE:BBY), and voila! Short sellers who saw the writing on the balance sheet made out like proverbial bandits between 2006 and 2008.
The financial sector's recent history provides loads of additional examples. Prior to being taken over by JPMorgan Chase (NYSE:JPM), for example, Washington Mutual's lending practices reportedly rattled some of the company's own business partners. Said one of those partners in a New York Times post-mortem: "If you were alive, they would give you a loan. Actually, I think if you were dead, they would still give you a loan."
Short people
Money manager Ken Heebner, meanwhile, is no stranger to shorting. Indeed, the semi-annual report for his concentrated CGM Focus (CGMFX) fund lists four shorts, GM (NYSE:GM) and Garmin (NASDAQ:GRMN) among them.
Heebner has also enriched his fund investors by taking short positions in Countrywide Financial -- a recent Bank of America (NYSE:BAC) acquisition -- and Sears (NYSE:SHLD), an example of a company that, while financially stable, competes in a marketplace that includes the financially much stronger likes of Wal-Mart (NYSE:WMT) and Target, faster growers that each sport more attractive valuation profiles than Sears.
A surefire short?
Sears shares declined by nearly 40% in 2007 and by nearly 62% in 2008. Yet even after that precipitous decline, the question remains: Is it still a short candidate? For many investors, the answer appears to be yes. At the end of 2008, roughly 15% of the company's shares were sold short, and insiders have been heading for the exits. Over the last six months, shares held by company players have declined 26.4%.
Sears' financials have come up short, too, with cash flow dwindling to just roughly $300 million over the last 12 months. Return on equity (ROE) -- a good way to gauge whether management is getting the biggest bang for its shareholders' bucks -- has been on the decline, too, with the company falling in recent years to the back of its industry's profitability pack.
On the other hand, the company has its adherents, including the gurus who manage the excellent Fairholme (FAIRX) fund. As of its most recently reported portfolio, nearly 12% (!) of Fairholme's assets were stuffed into Sears.
So who's right? Tune in tomorrow, or maybe the next day, or the day after that. When it comes to shorting -- or making dramatic long bets -- the time to bail out is virtually unpredictable.
The Foolish bottom line
Because I'm personally more interested in finding businesses worth owning (as opposed to those worth betting against), I'm a long investor at heart. Given that orientation -- along with my deep-seated cheapskate nature – I'm a big fan of my colleague Philip Durell's Inside Value service, an investment newsletter that aims to separate the market's values from its value traps.
As Philip pointed out in the newsletter's very first issue, his investing strategy involves "scouring the market for that company trading for 50 cents on the dollar. We're looking at good companies that have had a bad quarter or two, are turning around after troubled times, or are moving toward the high points of their business cycles."
If that sounds like a long-term investment game plan, click here to take the service for a risk-free spin. Your 30-day guest pass provides access to Inside Value's complete list of recommendations and its treasure trove of archival material as well. The shorts may have had most of the fun over the last year or so, but for my money (literally!), the future belongs to long (and long-term) investors who know where to find those viable, half-price companies.
Shannon Zimmerman runs point on the Fool's Ready-Made Millionaire service. At the time of publication, he didn't own any of the companies mentioned. Best Buy is a Motley Fool Stock Advisor pick. Best Buy, Sears Holdings, and Wal-Mart Stores are Motley Fool Inside Value recommendations. Garmin is a Motley Fool Global Gains pick. The Fool owns shares of Best Buy and Fairholme. You can check out the Fool's strict disclosure policy by clicking right here.
