All About SHORT SELLING

THE EASY WAY TO GET STARTED

By TOM TAULLI

The McGraw-Hill Companies, Inc.

Copyright © 2011 The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-175934-2

Contents

Chapter 1 What Is Short Selling and How Can It Help Your Investing?Chapter 2 Characteristics of Short SellingChapter 3 Risks and Costs of Short SellingChapter 4 Fundamental AnalysisChapter 5 Basic Accounting for Short SellersChapter 6 Analyzing the Balance SheetChapter 7 The Income StatementChapter 8 Statement of Cash FlowsChapter 9 Technical AnalysisChapter 10 Detecting Bear MarketsChapter 11 Trading StrategiesChapter 12 Shorting with OptionsChapter 13 Shorting CommoditiesChapter 14 Shorting with Mutual Funds, Hedge Funds, and Inverted ETFsChapter 15 Special Situation ShortsChapter 16 Risk ManagementGlossaryIndexShort Selling Resources

Excerpt

CHAPTER 1

What Is Short Selling and How Can It Help Your Investing?

Key Concepts

* Reasons for short selling

* What is short selling?

* How to short

* The history of short selling

One of the key tenets for money managers is to focus on investing for the longterm. Over the years, the volatile swings will even out and your portfolio willsteadily increase. By taking a buy-and-hold strategy, you should be able togenerate 7 percent to 8 percent average returns—when including dividends.This is what history tends to show.

But is this really true? Can the markets be stagnant for ten or even twentyyears? Yes they can. Keep in mind that the time between 2000 to 2010 is oftenreferred to as the “Lost Decade,” in which the Standard & Poor’s 500 Index (S&P500) averaged a loss of 0.5 percent per year (of course, it would have been evenworse when adjusted for inflation). This did not even happen during the 1930swhen the United States suffered from the Great Depression.

It is true that statistics can be misleading, as the first half of 2000 was thepeak of the bull market. If the comparison was done from 2002, the numbers wouldlook better. Yet few would argue that 2000 to 2010 was not without extremevolatility. In all, there were two major declines in the markets, which included2000 to 2002 and 2007 to 2008. The decade also saw a variety of negative events.There was the real estate implosion, the accounting scandals of Enron andWorldCom, the terrorist strike on 9/11, the wars in Iraq and Afghanistan, andtwo recessions.

But can there be two lost decades? Looking back at U.S. history, there areexamples of this. For example, the 1929 crash led to a grueling bear market. TheDow Jones Industrial Average (DJIA) did not recover until 1954. Another case isthe period from 1964 to 1982, which also saw a devastating bear market. There isalso the terrible experience in Japan. Since the plunge in the Nikkei Index in1989, the markets are still 75 percent off from the peak.

Unfortunately, the U.S. economy is certainly facing major headwinds, which couldmake it difficult for the markets to post strong gains. Consider the views oftop money managers at Pimco like Tony Crescenzi, Mohamed El-Erian, and BillGross. They believe that the U.S. economy will have a muted growth path for thelong haul. One reason is that many of the jobs lost in the 2008–2009recession will no longer return. Industries like autos, housing, construction,retail, and finance have undergone tremendous structural changes. CorporateAmerica has also learned how to manage with fewer employees by usingproductivity-enhancing technologies and outsourcing to economies like China andIndia.

There has also been a massive destruction of wealth. Since peaking at $66trillion, the overall net worth of Americans has fallen by about $10 trillion.This will likely be a drag on consumer spending, especially as the Baby Boomersget older and start to retire. They will focus on more conservative investmentsbecause they do not want to run out of capital. Another major drag on theeconomy will be increased regulations. True, the near collapse of the financialsystem meant that it was inevitable that the federal government would get muchmore intrusive. Yet this will make it more difficult for companies to operate.Despite the regulations, it is likely that U.S. financial institutions will berestrained in extending credit. The fact is the consumers still have large debtloads. What’s more, with lower growth prospects, there is not as much need forcredit.

The costs of the bailouts will also lead to higher taxes. At some point, thefederal government will need to take action to reduce the swelling budgetdeficit. And in light of the surge of retirements from the BabyBoomers—which will mean higher healthcare and Social Securitybenefits—it will be tough to find ways to cut costs.

In light of the potential challenges—and the complexities of globaleconomies—investors are likely to face more risk and volatility in thefuture. This is not to say investors need to avoid stocks or put money intoultra-safe securities like U.S. Treasuries. Instead, it means that it isimportant to look beyond just the purchase of securities—and consider howto make money when the values of investments fall. And of course, one effectiveway to do this is to use the investment technique of short selling.

MORE BAD STOCKS THAN GOOD ONES?

While any investor can have a hot streak, it typically does not last. Only ahandful of investors have been able to consistently beat the markets over aten-year period, such as Warren Buffett and Peter Lynch. Even with those whohave achieved this feat—like Bill Miller—there is often a periodwhen the returns eventually fall off.

The key to getting above-market returns is to find a few stellar performers.Picking stocks like Starbucks or Microsoft in their early years would have morethan offset the losers and average performers. Lynch famously called theseinvestments “ten baggers” (since they increased ten times or more).

Consider Li Lu, who is a candidate to manage Buffett’s $100 billion portfolio.Since 1998, his hedge fund has posted annualized compound returns of 26.4percent. This compares to the Standard & Poor’s return of 2.25 percent. However,a large part of the success came from an investment in BYD, which is afast-growing Chinese battery maker. Needless to say, it is exceedingly difficultto find these home runs. In fact, Li has found only one in his career. Actually,the fact is that—even for top investors—the chances are higher thata typical stock pick will fall in value. In other words, the odds tend to be infavor of short sellers.

This appears to be the case from a study by Blackstar Funds. The investment firmlooked at the performance of all U.S. stocks from 1983 to 2006. Given that thiswas during a large bull market, the typical return should have been strong,right? The conclusion is the opposite. About 39 percent of the stocks wereunprofitable and 18.5 percent lost at least 75 percent of their value. Only aquarter of the stocks accounted for all the value of the market.

REASONS FOR SHORT SELLING

Until recently, the topic of short selling was fairly obscure. It mostly madeheadline news when there was a major drop in the markets. As should be nosurprise, the short sellers are easy targets to blame when things go wrong.Because of this, there are lots of misconceptions about short selling. In manyinvestment books, the topic is rarely mentioned. And if it is, the coverage isspotty. Yet after the 2007–2008 financial panic, short selling hasincreasingly become a part of the investor’s vernacular. As a sign of this, ithas become a daily topic on CNBC as well as in top publications like theWall Street Journal and Barron’s. In fact, one of CNBC’s topjournalists, Herb Greenberg, often covers short-sale targets.

So even if you do not short sell a stock, it is still important to understandthe conversation. You may not even realize that some of your investments mayactually employ short-selling approaches. Or, by using the analytical techniquesof a short seller, you may be able to avoid stocks that are vulnerable for a bigfall. But if you do short sell—or want to do so—there are certainlyimportant benefits. Perhaps one of the biggest is that short selling can lowerthe overall risk in your portfolio. If 80 or 90 percent of your portfolio haslong positions, then a fall in the market will be partially offset by your shortpositions. This would have certainly been a big help to many investors duringthe 2007–2008 financial panic. Keep in mind, too, that some of the world’stop investors, such as hedge fund managers, routinely use short selling becauseit can hedge the downside in a portfolio. Examples include George Soros andJulian Robertson, who are billionaires.

Short selling can also result in quick returns. It is often the case that astock will fall faster and farther than when a stock increases. A reason forthis is that investors may panic when there is bad news and dump large amountsof shares. When this happens, it can be tough to find buyers.

It is actually getting easier to short sell securities. Over the years, WallStreet has introduced a variety of new innovations like exchange-traded funds(ETFs). These allow investors to make money when stock indexes fall. It is alsopossible to short real estate, commodities, and even countries. Despite theseadvantages, investors are often reluctant to engage in short selling. Theperceived risks are high and the process can be somewhat confusing.Interestingly enough, some investors think it is even un-American to short sellstocks. Consider that some thought the short sellers were the cause of thefinancial shock of 2008. Regardless, the fact remains that short selling iscommon in any modern market and attempts to make it illegal have often failed.

WHAT IS SHORT SELLING?

Short selling is pervasive throughout the world’s stock markets. To get a senseof the activity, look at the short interest activity on the New York StockExchange (NYSE) in mid-June of 2010. The volume was 18 billion shares, whichrepresented about 4.75 percent of the stock outstanding. Yet even though shortselling is a big part of the markets, the fact is that many investors still haveonly a vague idea of how the process works. Perhaps the main reason is that itsounds counterintuitive. How is it possible to make money when a stock’s valuefalls? This is actually possible because short selling reverses theprocess that people buy stock. That is, you sell the stock first and then yousell it later—hopefully at a lower price. If so, you will make a profit onthe trade.

Let’s look at this in more detail. First of all, an investor must find sharesthat can be borrowed. This is known as “the locate” or “the borrow.” Just aboutany brokerage firm has a department that focuses on this type of security. Keepin mind that it can be difficult, if not impossible, to borrow shares. This maybe the case if the stock is already heavily shorted and the brokerage firms arehesitant to engage in the trade. Or, it could be that a stock is lightly tradedand there are few shares available to short. Because of this, an investor maylook at alternatives. One approach is to purchase a “put option.” This is asecurity that increases in value when the underlying security falls. Or, aninvestor may short a futures contract on an index or even stocks.

These approaches can result in quick profits because of the leverage. That is,an investor need only put up 5 percent to 50 percent of the overall value of thecontract. But, of course, if the trade does not work, the losses can besubstantial.

Let’s assume you can borrow shares in XYZ Corp., which you believe will fall invalue over the next couple of months. To do this, you must first set up a marginaccount and have sufficient assets in your account. This is often $5,000 ormore. You then borrow 100 shares of XYZ Corp., which have a price of $40. Youwill then sell the shares and generate proceeds of $4,000. The process is oftendone within minutes or even seconds. The proceeds from this transaction willthen be kept in the account as security. Suppose a few months pass by and theshares of XYZ Corp. fall to $30. You can take your profit by “covering” yourshort. This means you will buy 100 shares for $30 and return them to yourbrokerage firm. In the end, you will have generated a $1,000 profit ($4,000minus $3,000).

THE CONTROVERSIAL HISTORY OF SHORT SELLING

Short selling is far from new. It got its start when stock exchanges emerged inEurope in the late 1500s. One of the hottest markets was in Amsterdam, which sawa massive bull market. A top firm during those heady times was the East IndiesCompany. Even with all the excitement and bullishness, there were some investorswho were skeptical, such as Isaac Le Maire. A top merchant, he had a good senseof the value of a company as well as how to detect troubles.

Based on his research, Le Maire believed that the East Indies Company was poisedfor a big fall. So he aggressively shorted the stock and even spread negativerumors about the company. He was ultimately proved correct in 1610 when theshares of the East Indies Company collapsed. The event was so significant thatthe bull market ended. Looking for a reason, investors pointed to Le Maire andother short sellers. The upshot was that the Dutch government banned shortselling. But this turned out to be useless as investors found creative ways toget around the rules.

This would not be the end of the controversy or the banning of short selling.The U.S. markets have also seen a variety of fights. The first ban came in 1812when the country was embroiled in a tough war. But over time, investors foundloopholes. It helped that the New York Stock Exchange was fairly inactive, withjust a few dozen companies traded on the market. So by the late 1850s, theUnited States ended the short-selling ban.

After the Civil War, the markets in the United States boomed as the countrybecame industrialized. Railroads raised large amounts of capital from WallStreet, as did other industrial companies. There were also new innovations, likethe telegraph and the ticker tape. Increasingly, the United States was becomingan economic superpower. And, stock market trading was getting much moresophisticated. With few regulations, a variety of entrepreneurs—known as”Robber Barons”—amassed huge fortunes. Unfortunately, it was not uncommonfor them to engage in market manipulation, false rumors, and even bribery. Itcertainly was a Darwinian environment.

An example was Daniel Drew. Despite being illiterate, he had an innate sense formaking large sums of money. He eventually teamed up with Jay Gould and Jim Fisk.Over time, they would speculate on the stock market—in terms of buyingstock and selling short. Their only goal was to make as much money as possible.

It should be no surprise that corporate executives would also participate inquestionable activities. Consider John Gates, who was the president of AmericanSteel and Wire Company. When he realized business was softening, he cut backproduction and laid off employees. At the same time, he shorted his company’sstock and made a tidy profit.

Even with several major market crashes and depressions, the U.S. government didnothing to restrain short selling. One reason was the belief in free markets.Shouldn’t investors be allowed to make money—even if the markets fall? Butthis attitude would change as the stock market crashed in 1929 and the economysunk into the Great Depression. By 1933, the Dow Jones Industrial Average fellby a staggering 89 percent.

During these tough times, some traders actually did make a fortune by shortselling. One was Jesse Livermore. He had a photographic memory for stockmovements. In fact, because of this, he was able to see patterns in stockchanges, which ultimately became the basis of “technical analysis.” It wasduring 1929 that Livermore made his biggest trade. He made roughly $100 millionby shorting the stock market. Yet it was somewhat of a Pyrrhic victory. TheAmerican public believed he was the cause of the crash and even the terribleeconomic problems. As a result, Livermore hired bodyguards and eventuallycommitted suicide in 1940.

Besides Livermore, another great Wall Street trader made a fortune from the 1929crash: Bernard Baruch. He actually wrote a book on the topic called ShortSales and the Manipulation of Securities. It was an attempt to show thatshort selling was not harmful. For example, he demonstrated that the concept isprevalent in many industries. After all, don’t many farmers sell their cropsbefore they plant anything? Or home builders sell homes before they are made?

Despite this defense of short selling, Baruch showed little progress in makinghis case. Instead, he tried to keep a low profile of his trading activities,which was definitely a good idea. Keep in mind that he would eventually become atop adviser to presidents Harding, Coolidge, and Hoover. In the aftermath of thestock market crash, Congress and President Roosevelt brought about substantialfederal regulations of securities and created the Securities and ExchangeCommission (SEC). What’s more, the federal government imposed variousregulations on short selling, including the “uptick rule” (which means it is notlegal to short a stock when the price is falling) and margin requirements so asto reduce the risks and volatility. But these reforms did little to stop shortselling.

Actually, by the 1950s, the emergence of hedge funds would make short selling acommon practice on Wall Street. With volatile markets, these hedge fund managersskillfully shorted the market. Interestingly enough, they would target brandname companies like Coca-Cola, GE, and McDonald’s.

Then by the 1980s, there was yet another important development in the evolutionof short selling: short-only funds. The innovators were threebrothers—Matt, Kurt, and Joe Feshbach. All they did was find short-saleopportunities—and they were certainly skilled at it. Then again, theyengaged in a tremendous amount of research.

In some cases, the Feshbach brothers would uncover frauds. This was thesituation with ZZZZ Best Company, which quickly went bust and generated aconsiderable profit for the brothers. With such successes, the Feshbach brotherswere able to raise a $1 billion fund. But as the bull market resumed in the1990s, the returns trailed off and the fund eventually changed its mandate toinclude long positions.

Another top short-only fund to come out during the 1980s was Kynikos Associates,led by Jim Chanos. He is considered one of the best short sellers of hisgeneration. Keep in mind that he spotted such trades as Enron and Boston Market.

THE BENEFITS OF SHORT SELLING

Despite the rancor about the evils of short selling, the fact is that there aremany benefits to the practice. If anything, it is essential for the functioningof a modern marketplace. Consider when the U.S. government placed a ban on shortselling during late 2008; it was actually limited to roughly 800 financialstocks. At the same time, there were a variety of exceptions, such as for marketmakers who needed to facilitate trades for buyers and sellers. In other words,short selling is critical for providing liquidity to the marketplace. As BernardBaruch once said, “To enjoy the advantages of a free market, one must have bothbuyers and sellers, both bulls and bears. A market without bears would be like anation without a free press. There would be no one to criticize and restrain thefalse optimism that always leads to disaster.”

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