Why Would I Waste My Time?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Some people will agree with me, and others will say I'm crazy, when I say I don't understand the point of trying to short a stock. A recent article by fellow fool Travis Hoium called “Shorting Stocks 101” lays the ground work for what shorting is, how it works, and why you might consider it. The problem I have is the ultimate gain with shorting a stock is always the same. Unless you are using leverage in some way, a traditional short position has the best possible return of 100%. If you short a company, you are betting that it's going to move down in price. Since there is no such thing as a negative stock price, $0 is as low as it gets. If you're on the long end of a trade, there is no cap on how high the stock can go. When I look at an investment that has 100% upside and unlimited downside it is just not a strategy that makes sense. Let me walk you through some of Travis' comments, and see if they make sense.
One comment that Travis makes is, “shorting stocks can reduce risk in your portfolio”. I only partially agree. If you are right about shorting the stock and the stock moves down, it will reduce your risk of losses. However, what if you are wrong? What if you bought Netflix (NASDAQ: NFLX) last July at $245? You would have been right today to have shorted the stock, but in the short run the stock ran up to $298.73. If while your other stocks were going up, you shorted Netflix, you've actually introduced risk to your portfolio that you didn't previously have. If you thought Netflix was overvalued at $245 you could have just not bought or shorted the stock. Staying on the sidelines is a perfectly reasonable response as well.
“A simple short strategy is to find a stock you think is overvalued and short it.” While this is a simple strategy, the question becomes how often are you exactly right? Peter Lynch once said that he didn't expect to be right in the market 100% of the time. He went on to say that out of every 5 stocks, 1 would outperform, 1 would underperform his expectations, and 3 would perform as expected. So we have arguably one of the greatest investors of all time saying, that he is only exactly right 3 out of 5 times. How many of us, have bought a stock we were sure was undervalued, only to watch it drop further? It works exactly the same in the world of shorting stocks. You might believe the stock is undervalued, but if other people don't agree, or if your valuation technique is flawed, you stand to lose a lot of money.
A great example of this is Gamestop (NYSE: GME). The company has one of the highest short interest percentages I've seen. Yet in the last two years, there have been at least 10 different directional changes in the price of the stock by at least 10%. The point is, there have been detractors of Gamestop's business for a while, and short sellers have been betting against the company. However, just because you short a stock, doesn't mean it will go down in orderly fashion like you think it will. The people who are short GameStop could be right someday, but in the meantime they have to be willing to add to their position if the stock goes up. This just isn't something you have to do in a traditional long position.
Now Travis does give some tips such as, avoiding companies like Gamestop that have high short interest to avoid a potential short squeeze. This again makes about half sense. It's true you will avoid a costly short squeeze if you avoid these high short interest companies. The problem is, many times the companies with the highest short interest are the ones that are in real trouble. Not shorting a company because a lot of other people are is, akin to not buying a company just because a lot of other people are. The point is, do your research and know why you think a stock is undervalued or overvalued and ignore what other people are doing. If your research is right, it eventually will show up in the stock price. If your research is wrong, it won't matter how much company you have, in being wrong you will still lose money.
Travis's last piece of advice was, find companies that are under-performers in their markets, are overvalued, and aren't never-ending growth stocks. If only it were that simple. The issue is, even underperforming companies can hang on for a long time and the stock might not go anywhere. In my opinion, you can use this technique to weed out companies you don't want to buy, rather than wasting time on what companies to short. There are numerous examples of well known companies that have returned a multiple of their original investment to long term shareholders. Without leverage, there are exactly zero examples where a shorted stock returned more than 100%. It all comes down to one simple formula:
Long position = unlimited upside vs 100% downside
Short position = 100% upside vs unlimited downside
While I espect your opinion Travis, the argument for finding good candidates to short comes up a bit...short for me.
Motley Fool newsletter services recommend Netflix. The Motley Fool owns shares of GameStop. MHenage has no positions in the stocks mentioned above. 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.