The Art of Short Selling

The origination of this quote is unknown but it is commonly attributed to John Pierpoint Morgan, or his long-term business partner, James J. Hill (immortalized in The Northern Pacific Corner of 1901):

““Remember, my son, that any man who is a bear on the future of this country will go broke.”

As long as capitalism is allowed to function (with just enough regulatory meddling to weed out the bad apples), I generally agree with this statement. In the long-run–barring a sizable Black Swan event (in which case we have other things to worry about)–the trend of equity prices and dividends is up. Shorting the market on a consistent basis is a sure way to ruin.

That said–given the “creative destructive” nature of the global economy and stock market–there is definitely a place for short-selling selected companies or industries.

Let us backtrack and define why. Here are some universal axioms.

We understand from the Second Law of Thermodynamics that the entropy of the universe, and that of the earth, is constantly increasing.

As such, it takes a tremendous and increasing amount of energy to hold a system or company in equilibrium. Any energy expanded on this endeavor (e.g. keeping the human body nourished) takes a giant toll on our surrounding environment, and sooner or later, things will fall apart. The beauty of the capitalist system is that it allows these changes/transformations to take place on a natural and gradual basis, unlike “static systems” such as various 20th century communist systems (such static systems tend to fall apart overnight as they were not allowed to evolve over time).

That is, increasing entropy + capitalism system = consistent short-selling opportunities.

While this formula sounds tempting, I always keep in mind that my criteria for shorting a stock is very strict. Firstly, I never short any stocks in the beginning of a cyclical/secular bull market cycle. This is the point when the WACC has peaked, liquidity has improved, and risk-taking is increasing. The Advance/Decline (A/D) line in all global stock markets troughs and starts to rise. This is also when the stock prices of the most leveraged and badly managed companies rise the most.

A good case can be made for shorting stocks/industries as the bull market matures–such as when the NYSE A/D line topped out in April 1998; or when it peaked in 1969. In the latter, many stocks that were not in the “Nifty Fifty” were good subsequent shorting candidates.

Now, I never short because of overvaluation alone.  I learned that lesson as a college sophomore when I shorted YHOO in early 1998 (thank goodness I wasn’t too dumb to cover after it started going against me). Rather, I only short stocks that fit one of the three following criteria:

1) IMHO, a company that is going bankrupt within the next 12 months;

2) If a company has fraudulent accounting or a fraudulent business (which I DO NOT have expertise in); and

3) A company that has an obsolete business model.

Even shorting a company that fits into 3) is very difficult as it could take years for the market to realize that a company has an obsolete business model (e.g. K-mart, A&P, or even Dell) so financing would generally still be available to keep the company as an ongoing concern (and there will be intermittent rip-roaring rallies). The best stocks to short are those that make you 50% while you are out at lunch (such as shorting Delta and Northwest Airlines in late 2005)–not those that make you 50%  (in the best case scenario) while giving you an ulcer. That said, we need to recognize that such shorting opportunities don’t come every day. More than buying a stock, patience is the key to finding shorting opportunities.

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