There are many obstacles to selling short. First, stocks as a whole tend to go up, not down, as time goes by. Second, you must pay to buy back your short if the stock goes up, which is called short covering.
But perhaps the greatest pitfall in shorting is that often people do it for the wrong reasons. Don't sell just because a stock's valuation is inflated. It's likely that the market price is someday bound to return to a reasonable level. The problem is that it is nearly impossible to predict the future and to know when shares will plummet. Often investors have shorted too early based on high valuations. Watching as the stock implacably rises, they panic and cover their short at a major loss. Really, the only way to time a valuation short correctly would be if you were extremely lucky or had insider information. Neither of these are recommended investment strategies.
Let's consider some examples of what not to short.
Amazon, ticker AMZN, has been seen as a valuation short. The basic short thesis was that a company which sells books and CDs on a website with no barriers to entry is not worthy of a high valuation. Although there is no inherent competitive advantage and perhaps someday another e-commerce rival might take away Amazon's market share, I'm not willing to bet against a company led by a strong and innovative management team which is able to generate about 20 percent net income growth year after year, even if on an earnings basis shares are expensive. So far, Amazon's shares have gained 25 percent during a one-year period and 377 percent during a five-year period, leaving many short sellers poorer.
Netflix, ticker NFLX, a company specializing in renting movies through the mail, or more popularly through their streaming services, is probably the most recent example of why shorting a stock because it has a high valuation is not profitable. Renowned value investor and hedge fund manager Whitney Tilson boldly shorted Netflix and posted his thesis on seekingalpha.com, generating vigorous debate. While Mr. Tilson does list other companies such as Hulu and Amazon - incidentally, Amazon recently launched a streaming video service consisting of 5,000 titles for its Amazon Prime members - taking away NFLX's market share, the core of the thesis is concern about the high valuation. Even The Wall Street Journal, which usually doesn't publish articles which attack stocks, has had some columns questioning Netflix's future success. Overall, it is probable NFLX will face competition which will beat down its high valuation. Despite these threats of competition, NFLX has so far run up more than 219 percent this year.
Tech stocks are not the only ones targeted as value shorts. Chipotle, ticker CMG, the burrito chain venerated by college students, is another company investors are betting against. The basic argument to sell is Chipotle's shares are too expensive and once the business reaches maturity, the stock price will fall to a level consistent with related mature business such as McDonald's. Initial back-of-the-envelope math backs up the short sellers' thesis: If the company earns $8 per share next year - Chipotle earned 5.64 last full year - and the average price-earnings ratio for its peer group according to Bloomberg is 23.75, then solving for price we'd arrive at 190 per share, a significant fall from its current $266 price. Although Chipotle is expensive compared to its peers, the growth potential of the company can justify the high multiples. Like the other stocks, the tricky part is knowing when Chipotle will reach maturity and valuation parity with its peers. No financial model or rough calculation can predict that with accuracy.
Despite the many headwinds, it is definitely possible to find good short opportunities. The best shorts are frauds and companies facing secular decline. Or as John Griffin of Blue Ridge Capital puts it, "The best shorts are those with fundamentally flawed business models that have suffered irreparable damage. Regardless of the stock price, you can sleep at night, knowing each day the company is destroying value." Frauds are pretty tough to spot as you need quite a bit of accounting knowledge to beat the Securities and Exchange Commission at its own game. Companies facing secular decline are much easier to identify. The most recent victim of technological change is Blockbuster, as customers have moved away from getting their movies at brick and mortar stores. Netflix also has taken Coinstar - which operates the Redbox movie rental kiosks - to the woodshed; shares of CSTR have fallen 20 percent during the last three months. Some say GameStop is the video game version of Blockbuster. As video games move toward the streaming delivery system movies have, the physical GameStop stores will crumble.
Overall, shorting plays a valuable role in the markets and the enterprising investor should consider shorting. But markets tend to rally after recessions, and remember: The rising tide lifts all boats.
Harrison's column runs biweekly Wednesdays. He can be reached at h.freund@cavalierdaily.com.
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