Contrarian Chronicles
The long and short of short-selling
This isn't a sport for amateurs. The downside is limitless, the subtleties complex. If you have the time to do the homework, here are some of the lessons I've learned the hard way.
By Bill Fleckenstein
Will everybody just settle down and squeeze together along the dissection table. No, you have not accidentally clicked onto some interactive biology lab. It's the latest chapter in the formaldehyde-free Contrarian Chronicles, where this week I'll offer a cross-sectional look not at splayed frogs but short-selling. Because of its complicated nature and inherent risk, this will be a demo class only. Still, fasten your safety goggles, and let's lace into that bird’s-eye view.New features
and free stuff.
Money 2003 is here.
I'd like to devote these pages to a discussion of short-selling, in the hope of answering the many questions I have received on the subject. Let me be clear from the outset: My goal is not to advocate short-selling but to differentiate it from investing on the long side and to highlight what I think are some of its complexities and complications. The reason I offer this caution is not any belief that people at home are not smart enough (I'm sure they are), but rather because of the time-intensive "babysitting" involved in monitoring positions. This is just how I do it, after many years of working the problem, but other successful short-sellers do it differently.
Portfolio plumping through value ingesting
First of all, let me preface my thoughts with some comments on the value approach to investing. When investing on the long side (as I have done in the past and will do again in the future), I am a value investor. Without going into everything that this means, the one thing it allows for is averaging down as your initial investment "goes against you." Many, many times in my career, I have successfully averaged down in positions. If you have the confidence in your research that you are not averaging down into a WorldCom (WCOEQ, news, msgs) or an Enron (ENRNQ, news, msgs) or some other debacle, averaging down allows you to enhance your rate of return.
For instance, suppose a stock that you're interested in is selling for $50, and for whatever reason, you think it could go up to $100. If, the stock drops to $40 and you decide to buy it because you are confident that the value is there -- and that the perception of the problems is overblown -- and it then goes to $100, obviously, you're going to make 150% on your money.
Whereas, in the same situation, if you don't buy it when things are looking rather bleak, and you wait until the situation improves somewhat, perhaps you pay $60 for it, you are paying up only 20%. But if the stock goes to $100, your rate of return is going to be 66%. So there is just one example of how, if you're confident that your analysis is correct, averaging down into bad news really helps your rate of return.
Apples-and-orange futures
Now, let's segue to the short side, where I believe that averaging up blindly can lead to disaster. Before going any further, I'd like to introduce one other element here: In the art of speculating in commodities, price action means almost everything. Commodity traders call it "price discovery." Successful commodity speculators don't often average up or down as the price goes against them (preferring to "average in," as the price goes in their favor). They might add to their positions a little bit as the price goes against them; however, when faced with a big move against them, they generally close a position and re-enter at a later period. Fundamentals do matter in commodities speculation, but price action tends to be a far bigger determinant, at least for people who are successful at it. The aspect of price action is much more important in commodities speculation than it is for a value investor on the long side.
As you can see from my previous example, I don't put much faith in price action when I am an investor on the long side. But on the short side, it is often necessary to cut and run if, say, you are short a stock at $20 and soon after it goes to $25, for reasons that you don't understand or which really shouldn't be happening. Often, it's wise to reduce your position, or eliminate it entirely, and then revisit the subject at a future date, whether that might be later that day, a week later, two weeks later or a month later.
Believe me, that was a hard and expensive lesson for me to learn, and it's hard for anyone who comes from the value school to learn, in my opinion. Also, I would just point out that this is not necessarily the way everyone does it, just the approach that I have found to be successful.
In any event, the reason you have to be much more sensitive about price on the short side is that your losses are of course potentially open-ended. When you have a problem in your short portfolio, it gets bigger, whereas when you're investing on the long side, if you have a problem, it gets smaller. You buy a stock at $10 and it goes to $5, your investment is now reduced. You short a stock at $20 and it goes to $30, the size of your investment has now gotten bigger. So, there are complicating factors that I believe necessitate paying attention to price action.
Short-selling satisfaction through delayed herd-reaction
Obviously, when you are short, you're generally taking on lots of other people, meaning it's vital to get your research correct. Further, in view of what I've described, timing is more critical, though just as elusive, on the short side than on the long side. During the last five to seven years, the presence of some sort of catalyst has been crucial for getting people to reappraise their long positions. Often, a company had to come out and tell you, hey, we're going to miss the numbers, or some variation on that theme, when it's been completely knowable in advance that this outcome would be in the offing.
But investors don't seem to take that into consideration until the company actually says so itself; i.e., stocks generally don't tend to move down in advance of bad news. Whereas on the long side, stocks will sneak and creep and work their way higher in the absence of a catalyst, i.e., move up in advance of good news. This may change somewhere down the road. It wasn't always that way in the past. But for the last several years, and until it does change, the onset of a catalyst has often been important for convincing people to re-evaluate their positions and sell a stock.
Consequently, that is the reason I focus on technology. Most technology companies have public suppliers and public customers, and that allows you to have a chance to triangulate in on how a particular company is doing. Also, most of the time, tech companies don't have the flexibility, in terms of accounting, to attempt to change things materially. When they do, by stuffing the channel, it shows up in their accounts receivable. Or, if they try to play the game with margins, it turns up in inventories. So a lot of the classic things they do surface rather easily. This doesn't mean that people will immediately care, but at least you can see signs of trouble building. (Financial stocks, by comparison, can fall back on more flexible accounting rules, with respect to how they view their assets, and thus postpone the day of reckoning ad infinitum, it seems to me.)
Of triangulation and nascent elation
Of course, the other important reason tech stocks are interesting is the inherent factor of obsolescence, which makes technology such a crummy business. Even today, the prices for those businesses are still absurd, in many cases. So, it's an interesting pond to fish in, for all three of the reasons I've stated: the difficulty of the business, the richness of valuations and the ability to triangulate on the timing of a negative catalyst.
While you are waiting for your catalyst to develop, whatever that may be, it's important to try to keep the fantasy, or the imagination component, of the bull camp at bay. This is why the preannouncement season (a month or so before the quarter ends) is a riper time to establish positions than just after the end of earnings season. It seems that no matter how bad the news is, as soon as the bad news stops, fantasies resurface, and people reaffirm their desire to bid these companies up. So, here is one additional factor to pay attention to: where you are in the corporate news cycle, whether you're in the "no news" season or the preannouncement period. That said, just being in either one of those two seasons doesn't mean that you can't have news, or have the absence of news. This also has to be taken into consideration.
Ingredients in the big macro
Lastly, one has to assess the overall macro environment, vis-a-vis whether people have become overly bearish or overly ebullient. For example, last fall, a couple of weeks after Sept. 11, I covered almost all my shorts, because I felt that from a macro perspective, people were going to believe that the terrorist attack was the cause of all our negative developments in the stock market and the economy (even though I knew it wasn't), and that as we went to war in Afghanistan and won easily, people would become optimistic. I felt it would be difficult for stocks to go down in the short run, and I said so at the time. That kind of a macro call was important last year. Yet, as you can see, it had nothing to do with anything I've described thus far.
So, I think one can see the many considerations that go into running a short portfolio which are not necessarily present on the long side. It is for these reasons that I advocate that people at home who don't have full time to devote to it, and who are not experienced, not try to do this, because it is so time-consuming and complicated. Often, I use puts in lieu of short-selling, but because of the premiums involved, and the necessity of getting the always-elusive timing even more precise, puts are no panacea, either. I'd like to repeat that the tactics I have described are not the only ways of doing it. This is just what I find most successful.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, William Fleckenstein owned none of the equities mentioned in this column. |
