And when you lose? Well…don’t expect much in the way of sympathy.
Given that you are constantly going against both popular opinion and the normal upward bias of the stock market, you have to be confident in your research when you take a large short position. But given that, in the words of John Maynard Keynes, the market can remain irrational longer than you can remain solvent, you also have to have disciplined risk management in place and be willing to cut your losses early.
This is a long way of saying that short sellers are a special breed.
John DelVecchio, co-manager of the Ranger Equity Bear ETF (HDGE)—a dedicated short fund— and manager of the Forensic Accounting ETF (FLAG), is one of those special breed. I reviewed DelVecchio’s book, What’s Behind the Numbers, about a year ago, and I consider it required reading for any aspiring short seller.
I can, however , summarize the book in one short paragraph. A sky-high valuation is not sufficient justification to short a stock, as expensive stocks often have a way of getting more expensive and gimmicky fad stocks can stay trendy longer than you think. You need a catalyst, and the signs for DelVecchio that the jig is up are aggressive revenue recognition and inventory management. Quoting What’s Behind the Numbers, “The time to sell or short is not when you think a business model can’t survive. The time is when the numbers suggest that management is covering up poor performance.”
With the market off to a slow start in 2014 and valuations looking a little stretched, you might be itching to try your luck as a short seller. Let’s take a peek at what DelVecchio and co-manager Brad Lamensdorf are shorting to find some promising candidates.
Top Five HDGE ETF Short Positions as of 1/20/2014
|Stock||Ticker||% of Portfolio|
|International Business Machines||(IBM)||-5.55%|
|Tempur Sealy International||(TPX)||-3.29|
Next on the list are telecom operator Centurylink (CTL),industrial supplier Fastenal (FAST) and heavy-equipment maker Caterpillar (CAT), all of which have struggled over the past year. Caterpillar in particular has faced a double whammy of lower demand from emerging markets and lower commodity prices, which have discouraged new projects. Rounding out the top five is Tempur Sealy International (TPX), which performed surprisingly well in 2013. Nearly two years ago, I wrote about the demographic trends driving Tempur’s business, suggesting that over the long term the business faced enormous headwinds. In the immediate near term, it will be the family formation of Generation Y (and the resulting need for new furniture) that makes or breaks the company.
Other shorts of note are Harley-Davison (HOG), Netflix (NFLX), Tesla Motors (TSLA) Michael Kors(KORS) and Kinder Morgan Energy Partners (KMP).
Last year, I wrote about “Harley-Davidson’s Flat Tire: Demographics,” and I share the managers’ bearish outlook for the company. And while I admire Netflix as a company, I have long been skeptical of the sustainability of its growth and its stratospheric valuation.
Tesla Motors–which was Kyle Woodley’s pick in InvestorPlace’s Best Stocks for 2014 contest (and the current leader by a wide margin)–is a risky short given its momentum, and one that I probably wouldn’t have the stomach to execute. The same goes for upstart fashion designer Michael Kors, which has taken the aspirational luxury market by storm in recent years. Though both stocks are significantly more expensive than the broader market.
Kinder Morgan Energy Partners is an interesting case. Hedgeye, a risk management and research firm, made a stir last year by calling KMP a “house of cards,” arguing that the company was engaging in aggressive accounting related to maintenance and capital expenditure spending. While I believe this is probably true, at least to an extent, I would hesitate to short a stock with heavy insider buying. As I wrote recently, Richard Kinder has put $60 million dollars of his own money into KMP’s general partner, Kinder Morgan Inc (KMI).
I’ll wrap this up with some general short selling advice from DelVecchio and co-author Tom Jacobs fromWhat’s Behind the Numbers.
First, don’t be too eager to jump into a short position. As DelVecchio and Jacobs point out, “You make as much money shorting a stock that falls from $70 to $5 (93 percent) as one that falls from $100 to $5 (95 percent).” Getting into a trade too early will turn a would-be profitable short into a frustrating loss.
Second, watch out for crowded trades. Don’t short a stock if the short interest is too high as a percentage of the float. This puts you at risk of being short-squeezed as your fellow sellers all scramble to buy at the same time and send the share price to the moon.
About the author:
Mr. Sizemore has been a repeat guest on Fox Business News, has been quoted in Barron’s Magazine and the Wall Street Journal, and has been published in many respected financial websites, including MarketWatch, TheStreet.com, InvestorPlace, MSN Money, Seeking Alpha, Stocks, Futures, and Options Magazine and The Daily Reckoning.