Over the years as a writer about things financial, I would occasionally tease my readers with this line or a variation of it: “I bet you’ve never made a cent buying stocks.”
The kicker, of course, is that stock-market investors don’t make money until they sell the stock that they previously bought. The profit comes with the sale, not the purchase.
That is, except when it comes to short selling – the practice of borrowing shares of a company, selling the stock and then buying back the shares to return them to the lender. The short-sell transaction is a bet that the shares you sell will drop in price. And if that happens, you will make money when you buy back the shares at the lower price.
Short selling is inherently risky. When you buy a stock, the most you can lose is the purchase price, and there’s theoretically no limit to how much you can profit on the upside. When you short sell a stock, there’s a ceiling as to how much money you can make (equal to the amount you originally spent). More worrisome, though, is the veritable bottomless pit that can swallow you if that stock keeps rising.
Still, if you can afford (and can stomach) the risk, short selling can be an effective way to take advantage of an overbought situation and provide your portfolio with a dose of diversification. In the article below, contributor Dave Sterman identifies what he believes could be just such an opportunity.
— Bob Bogda, Editor
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When it comes to investing, a dose of skepticism is always warranted. Short sellers, for example, provide a healthy reality check on flawed business models, out-of-whack valuations, and self-serving or deceptive management teams.
Short-selling is a strategy in which an investor borrows a security – usually from a broker-dealer – and sells it on the open market with the idea of buying it back later at a lower price. Instead of buying low and selling high, short sellers seek to first sell high and then buy low. In other words, it’s a bet that a security will go down in price.
(To be able to sell stock short, you will need to fill out an extra form with your brokerage firm that authorizes you to make such trades).
Trouble is, short selling can be painful. As the markets went into hyper-drive these past few months, short sellers saw their investments erode until they had to throw in the towel.
And the way short sellers get out of their positions is by buying back those shares – hence the term “short-covering” – which, in a rising market, often has the effect of pushing prices higher still. That helps explain the summer of 2020 “market melt-up.” Thanks to short-covering, the train sped down the tracks even faster.
To be clear, if the market is surging higher and your short sale investment is losing value, it often makes sense to close out that trade and save your funds for another day. Short-selling is by no means a risk-free or “set-it and forget it” approach. You’ll need to monitor your investments daily to ensure you don’t get caught up in a market melt-up like we saw this summer.
How do you know when you are in a market melt-up? When you see shares of large companies like Salesforce.com (CRM), Netflix (NFLX) and Facebook (FB) post one day gains of 26%, 12% and 8%, respectively, on quarterly results.
But the current market melt-up may be approaching its final phases. After topping 12,000 for this first time, the mighty Nasdaq Composite Index slid more than 1,000 points in just three trading sessions in the early days of September (before a subsequent rebound).
More to the point, the stock market’s valuations are looking quite stretched after the recent melt-up. The S&P 500 sports a price-to-earnings (P/E) ratio of 29.2, nearly double the historical average. In the face of an uncertain economic outlook and a tempestuous political season ahead, that’s worrisome.
For some, the recent market pullback raises the question of whether it is time to lock in profits. For more intrepid investors, there is a growing sense that profits can be had from further market weakness. Once again, the notion of short selling is on trader’s minds.
Tesla (TSLA) helps paint the picture. Based on the value of shares held short, it was the most heavily shorted stock on the Nasdaq or NYSE as of mid-August, according to marketbeat.com. The fact that this stock lost 33% of its value in just five trading sessions tells you just how profitable short selling can be.
Other heavily shorted stocks in terms of dollar volume include Moderna (MRNA), Uber Technologies (UBER) and Simon Property Group (SPG).
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So how do you find the right stocks to bet against? Analyst sentiment is one good gauge. Wall Street analysts aren’t especially good at establishing price targets (as I learned from years working on the Street). But they are quite good at assessing when a stock’s market value becomes disconnected from its intrinsic value, based on measures such as growth and profits.
Perhaps it is no coincidence that there has been a growing number of “sell” ratings slapped on Tesla. It was reported last week that that of more than three dozen sell-side analysts polled by FactSet, eight rated the shares a “buy” while 11 rated them a “sell.” Exxon (XOM), American Airlines (AAL) and Southern Copper (SCO) are among other stocks that have more sell ratings than buy ratings these days.
It’s also wise to gauge if a stock’s trading float (the number of shares that actually trade freely on open markets and not just held tight by insiders) is increasingly controlled by short sellers. Websites like shortsight.com and iborrowdesk.com can help identify which stocks have especially large short sale positions in relation to the trading float.
While there are numerous richly valued stocks in today’s market, you shouldn’t rely on valuations alone to decide to short a stock. Instead, you want to identify potentially negative catalysts for the months and quarters ahead.
Simon Property Group (SPG) surely meets that criterion. As of mid-August, 27.5 million shares of this company were held short, higher by around 500,000 shares from two weeks earlier.
Simon Property Group owns 99 shopping malls, 69 premium outlets and a handful of other retail properties. The Real Estate Investment Trust (REIT) was in the news recently as it invested in beleaguered retailer JC Penney (JCPNQ) to keep yet another set of mall anchor stores from closing.
The primary investment thesis for short sellers is the near-term strain that the COVID-19 pandemic puts on financially weak brick-and-mortar retailers, and the longer-term threat that Amazon.com (AMZN), Walmart (WMT), Target (TGT) and other firms pose from the ongoing shift to e-commerce.
You can already see Simon Property Group’s financial results start to weaken. In the second quarter, the firm generated $2.12 a share in cash flow, below the $2.31 a share consensus forecast, and 29% below year-ago levels, according to Zacks Investment Research.
Rising levels of short interest suggest that this negative trend will remain in place or even accelerate as more retail tenants at malls go belly up.
Action to Take: Short sell shares of Simon Property Group at prices down to $60 (from a current $65) and prepare to close out that trade when shares re-visit the 52-week low of $45.
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