The Case for Short-Selling

Discussion in 'Wall St. News' started by Free Thinker, May 16, 2006.

  1. By Doug Kass
    Street Insight Contributor
    5/16/2006 1:15 PM EDT
    Click here for more stories by Doug Kass

    Editor's note: This column by Doug Kass is a special bonus for and RealMoney readers. It first appeared on Street Insight on May 15 at 9:34 a.m. EDT. To sign up for Street Insight, where you can read Doug Kass' commentary in real time, please click here.
    Many investors have a general misapprehension about short-selling.

    They shouldn't.

    When done conservatively and with risk controls in place, it is a fertile strategy for successful hedging and for the generation of absolute returns in most market settings.

    In fact, short-selling and hedging are a growing necessity in an uncertain world, especially in a more lumpy and uneven period of economic growth that is likely to follow the stock market bubble's piercing, and after four years of unprecedented fiscal and monetary stimulation.

    Still, there are the skeptics.

    Many consider short-selling a mug's game for a couple of reasons:

    1. The gravitational pull (higher) of equities over extended periods of time (about an 8% annual rate of return).
    2. The asymmetric risk/reward of a short -- one can make "only" a maximum return of 100% (in a bankruptcy), but an infinite risk is apparent on the upside.
    As well, many short-sellers have been decimated in rising markets because they have concentrated on heavily shorted (and speculative) equities and demonstrated little discipline in limiting losses. Moreover, some of those short-sellers have shorted on the basis of conceptual or valuation issues, the timing of which is inherently uncertain, and the market outcome has been consistently poor.

    To put short-selling into perspective, of all the hedge fund asset classes, short-selling is the least populated and most underserved. By definition, this provides a unique opportunity to generate excess returns. The entire dedicated short pool in the U.S. is estimated at less than $5 billion, or about only 6% of the size of the Fidelity Magellan Fund.

    Despite the influence of New York Attorney General Eliot Spitzer's attempts to regulate Wall Street research, the analytical output of Wall Street is still dominated by purchase recommendations. Wall Street exists for a purpose: not to produce disinterested research but to raise capital for a growing America by selling stocks and bonds. (The higher the market rises, the easier it has been to sell, but the more disingenuous the sales pitch becomes!)

    Market participants want to look on the bright side. Individual and institutional investors and the management of the corporations are invariably biased and bullish. How else to explain that nearly every money manager interviewed in the media is constructive? Consider whether you have ever witnessed an interview with a corporate executive who was bearish on the future of his company.

    In my numerous appearances on CNBC's "Squawk Box" and in other venues, I have never encountered such an animal. (This is one of the reasons I rarely visit corporate managers in assessing a company's outlook.)

    Common Mistakes
    All too often, short-sellers make tactical errors in establishing a short book. Among those common mistakes are the lack of diversification (along companies and industries), being fully invested (through thick and thin), the utilization of too much leverage, shorting hard-to-borrow stocks, shorting on the basis of valuation (or a concept or prices) and creating a short portfolio almost entirely based on the search for frauds (a needle-in-a-haystack approach).
    For example, it would be a mistake to short a concept stock such as Google (GOOG:Nasdaq - news - research - Cramer's Take), or a "new paradigm" stock such as Phelps Dodge (PD:NYSE - news - research - Cramer's Take). Although Phelps Dodge is far from a concept stock, the shares have doubled during the past year and are emblematic of a new paradigm in industrial commodities. I may short this type of stock periodically, but only with proper risk controls. You need to keep your eyes on the road, your seat belt fastened and one foot on the brake at all times.

    Basic Tenets to Short-Selling

    Through independent analysis, develop a variant (and negative) view of a company or industry's prospects, its business model or a company's quality of earnings. Logic of argument, power of dissection and the rejection of convention and orthodoxy -- in seeking a variant view against the market's prevailing view -- should form the basis for initiating short ideas.
    While discovering frauds seems like a sexy practice, it is impractical to structure an entire or a large portion of a short portfolio on the basis of frauds. (Even if one is successful in creating a short book consisting only of frauds, the timing and market acknowledgement of fraud might be unsuitable for a portfolio that is designed to prosper in market downdrafts.)

    Never employ leverage. In fact, when conditions dictate inaction on the short side, raise the portfolio's cash positions, as it is better to be conservative than sorry.

    Create a diversified short book. No individual equity position should exceed 2% of your portfolio's assets.

    When a market is dramatically overvalued, I recommend the use of out-of-the-money calls (against your shorts) as a means of buying time for a short catalyst to develop (because market moves to the upside, as well as those to the downside, usually last longer than most investors anticipate). This also helps define individual equity and portfolio financial risk/exposure and allows you to sleep at night (and be of sound mind during the day).

    Take losses quickly, and let your profits run. Remember that the basic rule to investing, in both buying long or selling short, is not to lose. (The second rule is not to forget the first rule.) The desire to stand out at any cost, or an unrelenting negativism, is faux pessimism.
    Although the true contrarian resists too-popular trends with sometimes grim resolve, he must realize that being plain stubborn is not necessarily being smart. Crowds are not always nuts as a society, and the market's wisdom always deserves some respect. But I have learned that the greatest danger to prices and valuation is a slavish subjection to tides and trends, and that as distinct as each market/sector bubble might be, the psychology that drives investors is always the same.

    In stocks, whenever you are certain that there is no way to go but up, look down. When everybody's blazing away, hold your fire. (And when everyone agrees the future is hopeless, invest or cover.)

    Don't look for management to help you in your analysis. Indeed, don't bother visiting management except to develop an understanding of a company's business. Warren Buffett, in the late 1980s, wrote to the shareholders of Berkshire Hathaway (BRK.A:NYSE - news - research - Cramer's Take) that "managers lie like ministers of finance on the eve of devaluation."

    Given the asymmetry of risk and reward, the construction of shorts is almost as important as the short itself. As mentioned previously, this can be accomplished by buying puts, or through the protection of out-of-the-money calls during halcyon times.

    Avoid illiquid and heavily shorted stocks. If you don't, eventually a short squeeze will be the outcome, and there will be heavy losses with it.

    Trade around your short positions, and ladder your shorts with the timing of expected catalysts (in terms of the calendar) to ensure superior performance and participation in market downdrafts.
    The Next Five Years
    Poor management, frauds and eroding company or industry trends always will be in fashion, regardless of market conditions. That said, several new secular developments seem to be setting the stage for a rocky and below-trendline outlook for equity returns over the balance of this decade.
    Uneven economic growth in 2006-2010. After a period of speculation (like in the late 1990s) followed by unprecedented fiscal and monetary stimulation, the 2006-2010 economy is likely to make for a much more difficult period for corporate managers and investment managers to navigate. A period of lumpy and uneven economic and profit growth (and a continued debasing in the U.S. dollar) seems likely -- a rich environment for short-selling.

    Growing geopolitical danger. The geopolitical landscape has changed for the worse, and unfortunately, it is not likely to improve for years. This risk will almost certainly be accompanied by the headwinds of higher commodity and energy prices.

    A secular rise in the rate of inflation. The benign inflationary backdrop of the last two decades seems to be in the process of being reversed.

    A widening schism between haves and have-nots. The social and economic risks associated with the increasingly disenfranchised lower- and middle-income classes (and their deteriorating real incomes and lack of participation in the economic recovery/boom) pose an intermediate-term threat to the domestic economy.

    A brave new world reliant on asset appreciation is filled with risk. An economy based on continued asset appreciation (equities and homes), as compared with the more traditional role of wages and salaries as locomotives for growth, holds new risks. This will serve as a slippery and uncertain slope for policymakers and investors.

    Editor's note: This column by Doug Kass is a special bonus for and RealMoney readers. It first appeared on Street Insight on May 15 at 9:34 a.m. EDT. To sign up for Street Insight, where you can read Doug Kass' commentary in real time, please click here.
  2. 999x999


    Doug cant even admit he worked for Tony Bruan. Seek out the guy who worked for Doug during the Kass days of J. W. Charles, he will tell you about the real Doug Kass. Short of that, I'm a seller....
  3. Corelio


    Oh yes...the gems of wisdom never backed up by proper testing and filled with popular jargons.