3 ways to short sell a stock and make money on the way down

Most investors are used to buying long – you buy low and sell high (or that’s the plan anyway!). Short sellers, on the other hand, sell high and then buy low – they sell a stock first believing that its price will drop, and then buy it back at a lower price once it does.

Short selling is an art that is rarely successfully practised in the investing world because it is riskier and more dangerous. Of the many successful investors that have gotten incredibly wealthy, successful long/short or short-only investors represent just about a fraction of the total.

Jim Chanos is perhaps the most famous short seller. The difference between Chanos and the likes of Ackman, Einhorn and Soros is Chanos only goes short – his Kynikos Associates fund purely focuses on short selling unlike many activist investors or global macro traders. Chanos was made famous for his short on Enron and has been a bear on China for a long time. The fact that Chanos is the only name out there that rings a bell or two compared with the likes of long-only Buffett, Lynch, and numerous others show how risky short selling is.

Why do people do it? It’s usually a show of mettle – it takes incredible skill, knowledge and timing to have a short position do well. Various long-short equity hedge funds practice this as a form of a hedge against market downturns and to generate alpha. An example of a pair trade would be to long Amazon and short Walmart – a play on the future of retail.

There are endless numbers of people screening for “undervalued companies” or “value plays” and the chief complaint now as the market has been roaring higher (thanks Trump) is that there are no cheap stocks left to buy. Think the opposite – this means there are more expensive stocks out there which are overvalued and short opportunities are in abundance. No consistent machine screening can fully capture this, which makes it a niche and because it takes too much hard work for people to do it. Analysts and managers are rarely ever trained in using examples of poorly run companies.

You hear of local investor complaints of lousy management running horrible companies or the famed short-seller attacks on Olam and Noble claiming accounting impropriety on the part of management (to the point of using drones to capture aerial footage of a non-existent construction of facilities). These announcements usually make quick work of the company – sending its shares spiralling down in a violent manner within the span of hours.

This article focuses the first example – on companies with lousy management that are running the ship into the ground. You don’t need to have a hundred million bucks or Sherlock Holmes as your in-house investigator to be a highly successful short seller as many people might wrongly presume, but you do need a steel stomach to handle short selling if you ever encounter a horrible company whose price you think is unsustainable.

Short candidates

In broad strokes, ideal short candidates can be broken down into three categories:

1. Companies with dishonest and lousy management

Horrible management is sadly not as uncommon as you might think. As explained in a previous article: sudden changes in KPI, ridiculous compensation schemes, disappearing management initiatives, avoidance of tough questions, heavy insider selling, use of big certainty words or just a dishonest tone of voice are signs of an ideal short candidate.

Although bad management may seem attractive to short sellers, it will depend on the company that they are running. If it’s an established business that even a monkey could run and the company would still survive, bad management wouldn’t really affect its fundamentals.

2. Companies with bubble-like stock prices that do not justify its valuation

It’s not a bubble when people say it is. However, many short candidates needn’t be in bubble territory to warrant an investigation. Most short candidates are usually expectation shorts – a psychological game rather than a purely technical short, and it usually affects growth companies.

Take Nvidia for example, it has seen its stock soar 4x in just a year due to the high demand for GPUs to run artificial intelligence (AI) systems in almost every data centre. Nvidia has been organically growing at a rapid clip and its fundamentals are very strong and they sit right in the middle of one of the biggest runways for growth in the rush for AI computing.

When it reached frothy levels above $100, everyone suddenly became an AI and GPU expert, with endless sell-side analysts initiating coverage on the stock and articles on Seeking Alpha generating hundreds of comments. This gives budding short sellers an opportunity – the perfect expectation short.

It was unloved in the beginning of 2016 and no one has heard of how GPUs are crucial for processing AI. When the stock then soared to triple digits on rapid earnings growth, it suddenly became the darling of Wall Street. Analysts expected massive growth and Nvidia delivered in the third quarter of 2016. The market then went: “Okay, since you keep beating our estimates, let’s give you a ridiculous figure to hit for 4Q 2016”.

Their 4Q 2016 was a doozy – EPS beat estimates by 36% and revenue beat estimates by 38%. The market, however, wasn’t satisfied by this stellar result, sending Nvidia’s shares down 15% within weeks.

When the market has ridiculous expectations on a company, great or not, the stock often trades at a rich multiple and all it takes is one “missed” quarter to send the shares violently crashing. This usually happens to market darlings and not fraudulent companies that many people mistakenly stereotype short sellers go hunting for.

3. Companies that are highly sensitive to external events

Firms that are in cyclical industries often see their stock prices gyrating to the general economic or business cycle. Knowing when an industry is grossly oversupplied and a downturn is due would be useful in timing one’s entry into a company that’s most vulnerable to said downturn.

Commodities firms tend to be highly levered (figuratively and literally) to the underlying commodities they operate with. The recent crash in commodities has exposed the weaknesses within structurally weak companies with many filing for bankruptcy. Short candidates can be found in any industry, especially when they do well during an industry upcycle and start being greedy by overspending, thus creating an oversupply.

Screening for shorts

As we’re now inverted, refer to the articles on looking for investment red flags and use it as a template to find companies that tick nearly every criterion.

  • Read the Risk Factors section in the company’s prospectus or annual report, study it carefully and evaluate the probability of the risks occurring.
  • Greed – Has the company been embarking on lavish rewards for management or buying glitzy properties at inflated prices for its new headquarters?

Short selling risks

Capital losses

Short selling is inherently riskier than going long. For one, you risk a 100% capital loss when you go long a stock as it can only go to zero. Conversely, you risk infinite capital losses when you short – the sky is the limit, imagine shorting Berkshire shares in the 70s.

There have been spectacular hedge fund blowups that make the news, but a more relatable one would be Joe Campbell’s $35,000 short on KBIO that blew up and he ended up owing his broker $106,000. KBIO was trading at liquidation value and he believed that they would go bankrupt. However, an investment consortium led by Martin Shkreli acquired more than 50% of the outstanding shares in a bid to turn the company around. The stock rose 650% instantly. Campbell started a GoFundMe page seeking to crowdfund his margin call; Martin Shkreli reportedly gave him $5.

Negative interest/dividends

By going short, you have to pay any dividends that your shorted company declares. That is on top of the borrowing costs that you will incur by shorting the stock – you’ve loaned the shares from your broker, and as with most loans, they carry interest that you’d have to pay to the lender. Different shares will have different borrowing costs depending on the level of supply – the more difficult it is to borrow a stock, the higher the interest charged.

Short squeezes

This is common among stocks with high short interest which tends to be more behavioural than technical. When everyone’s bearish on a stock and expecting it to go bankrupt, all it takes is one positive development to send the shares soaring, triggering broker-induced forced position closing and margin calls, which would exacerbate the situation.

Regulations

It can happen at any time, from developing markets like China or advanced ones like the United States, regulators have often banned short selling, which gave embattled stocks temporary reprieve, or to short sellers – a sudden surge in prices that forces them to cover their shorts.

Takeover risks

Takeover risk is always present in all companies, good or bad. The KBIO example above is one. This is easier to predict than regulatory risks. Several factors affect the probability of a takeover for a short candidate:

  • Size – The bigger the company, the harder it is to be taken over, particularly for private equity funds.
  • Management – Deeply entrenched management is less willing to sell their company versus a very willing seller.
  • Activists – Activist investors are often catalysts in price movements of shares. If there already is an activist in the stock, depending on whether they are long or short, watch their moves closely.
  • Valuation – Look at the industry, what is the common target multiple for takeovers, comparable transactions are the best guide and it will show you a sense of how much losses you may incur.

The fifth perspective

Shorting a company doesn’t necessarily mean you expect it to go to zero. In fact, it’s rarely a possibility unless it’s a massive fraud. Even the three local stooges (LionGold, Blumont and Asiasons) are still trading above zero. Treat them like you would a trade, and NOT an investment: Set a target price and stringent risk parameters and only allow a small percentage of your portfolio to be allocated to a short position.

Finally, stay within your circle of competence! While it’s good to know how short sellers can affect the market, you don’t have to be one yourself. If short selling is something that sits uncomfortably with you, then avoid it and just focus on investing long.

Matthew Lim is an equities and fixed income investor. He has a great curiosity of how markets, economics, and human behavior influence each other. He believes that an understanding of human irrationality and solid fundamental analysis allows an investor to seize opportunities and ultimately profit from the market.

3 Comments

  1. DW

    March 11, 2017 at 10:39 am

    So what are the 3 ways or methods to short sell?

    I do read from the article 3 types or categories of equities which short sell might be rewardful..

  2. Anthony

    March 21, 2017 at 12:07 am

    Hi Matthew, thanks for sharing this insightful
    article above.
    I was wondering if you can share with us which trading platform you used for short selling? Or any other recommendations.
    I am interested to know more about it.

    • Matthew Lim

      March 21, 2017 at 10:54 am

      Hi Anthony,

      You’re most welcome! I personally use Interactive Brokers but I believe most brokers should allow short selling on their platforms.

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