We took our first short position in the Intelledgement Speculative Opportunity Portfolio (ISOP) this week, by selling 178 borrowed shares of Beazer Homes (BZH) for $11.18 a share.
The mechanics of this are simple:
- You place an order to sell shares of a stock you don’t own
- Your broker attempts to borrow the shares and, if successful, sells them for you, placing the proceeds (minus his commission) in your money market account
- So long as you maintain this position, the current value of the shares (number of shares multiplied by the price per share) shows up as a liability in your brokerage account
- To close your short position, your broker buys the same number of shares you sold, returns the newly purchased shares to where they were borrowed from, and decrements your money market fund to pay for the purchase (and for his commission)
The vast majority of individual investors never short a single stock in their entire lifetimes. There are a variety of reasons for this. One big reason is that shorting is inherently more risky than “going long” (buying a stock). Overall, the market tends to go up 10% per year so there are generally fewer stocks going down than up. Mathematically, therefore, it is more likely that any given stock—all other things being equal—will go up than down in an average year.
Also, your upside is limited. If you sell a stock short, the best you can do if the company goes out of business and the stock becomes worthless is keep 100% of the money you were paid when you sold it. If you buy the same stock and the company does really well, the stock could triple or quintuple or more…everyone knows the apocraphyl story of the couple who invested $10,000 in WMT when Wal-Mart went public in 1970 and now are sitting on $53,000,000.
Conversely, the worst-case scenario for shorting is…well…worse. If you buy a stock (go long), the worst thing that can happen is that the company goes bankrupt, the value of the stock plummets to zero dollars per share, and you lose 100% of your investment. But let’s say your research uncovers a consulting services company that the market is (over)valuing as if it were a software publisher (software publishers have much higher profit margins than services companies)—so you sell short 100 shares at, say $10/share expecting the price to fall to $5/share. Unfortunately for you, it is the middle of the dot com boom, the market is irrationally exuberant, and the share price runs to $60. You were paid $1,000 when you sold the shares short, but to buy them back now, you need to come up with $6,000…and you only have $3,000 in cash in your brokerage account…and now your broker calls and says you either have to deposit another $3,000 or else he will be forced by the margin requirement rules to sell off some of your other holdings to raise the money to close out your short position…which will saddle you with a $5,000 loss. Theoretically, the value of the stock could keep on rising and thus the limit on your loss for your short position is…well, theoretically, infinity.
Some folks also object to shorting a stock on philosophical grounds. It’s one thing to research a company, understand the vision of their management, learn their strengths and weaknesses, and conclude either that you both believe what they are doing is worthwhile and likely to be profitable—and put your money where you analysis is—or not. If decide to invest, then you can root for them, exult in their triumphs, possibly even advise them, and, if they start screwing up or having bad luck, cut your losses and move on. It’s quite another to find a company which you discern is badly run, or facing difficult strategic circumstances, or is just overvalued, and sell their stock short. In effect you are actively rooting for them to fail. If your analysis is right, then you will profit from the misfortunes of others, who may lose money or their jobs or—in extreme cases—face criminal charges.
And, of course, it’s an image thing. If you say “stock market,” virtually no one associates those words with selling short. It’s like marketing cars…the image that comes to mind is zooming down an open road on a sunny day…sometimes there is no road if the ad is for an off-road vehicle…sometimes it is a dark and stormy night if the ad is for a particularly safe vehicle…but you never see the cars going in reverse. Remember Vin Diesel’s great hard sell scene in Boiler Room? Those calls are never about selling short; they are always about buying something.
Our view is that while reverse gear may not be sexy and is rarely employed, it would be hard to drive a car effectively if you couldn’t go backwards in some situations. When we sell short, we are not necessarily rooting for the company to fail—although as badly as Beazer has behaved here in North Carolina, we won’t be shedding any tears for that management team if, as we expect, things continue to deteriorate for them—but rather we are doing our level best to help the market properly value that enterprise. It is not healthy for the economy for Yahoo! to be valued at $200/share because it distorts decisions and leads people to move in directions that are not optimally productive. Anybody wise and brave enough to short YHOO at $200 in 1999 deserves as much credit for helping make our markets efficient as anyone who plunked down $10,000 for WMT in 1970.
Our macro analysis tells us that the real estate bubble has a long way to contract before it’s done, and our review of Beazer tells us that they are in worse shape than most homebuilders. Having the option to stake out an appropriate position—in this case, a short position—is a no lose proposition: if we are right, we will profit and if we are wrong, that will call into question a lot of other expectations which may need to be adjusted…sort of a canary-in-the-coal-mine. In this case, the canary is expected to expire but if it keeps on singing, then we are dealing with an unanticipated supply of oxygen, which is the sort of thing it’s good to know about sooner rather than later. Oxygen and coal dust can be an explosive combination, and we sure don’t want our investments blowing up unexpectedly.