Lessons From 15 Years Of Short Selling: 12 Reasons Not To Short

Whitney Tilson  |

Over the nearly two decades that I ran a hedge fund until I closed it last September, I was an active short seller. There were some epic highs - most notably identifying in early 2008 the bursting of the housing bubble and discovering in 2012 that Lumber Liquidators ( LL) was selling formaldehyde-tainted, Chinese-made laminate flooring, both of which landed me on 60 Minutes - but overall I lost a lot of money over the years on the short side.

Shorting is brutally difficult, especially during a long, complacent bull market like this one, which is why I advise most investors to learn about short selling - there are many important skills and lessons from which all investors can benefit - but not actually do it.

That said, I think the increasing level of overvaluation, complacency, hype and even fraud in our markets (can you say “bitcoin”?) make it a fantastic time to be looking at opportunities on the short side. I also think that short sellers are very healthy for our markets, especially the ones with the courage to go public with their bearish views.

For both of these reasons, I’ve organized a one-day conference in NYC on Thursday, May 3, The Art, Pain and Opportunity of Short Selling, to give two dozen of the world’s best short sellers a platform to share their wisdom and best, actionable short ideas (a list of speakers, further information and registration is available at kaselearning.com; Readers can get 10% off by using discount code SA10).

In advance of the conference, I’m writing a series of articles under the title, Lessons from 15 Years of Short Selling. In this, my first article, I want to start by making the case for how difficult shorting is and why, for most people, it’s not likely to be a profitable endeavor, nor a good use of time and energy.

In many ways, shorting appears to be nothing more than the inverse of long investing. On the long side, investors generally seek companies with good management, strong growth, high margins and returns on capital, clean balance sheets, and sustainable competitive advantages - all at a low price. Conversely, short sellers look for weak or dishonest management, low or negative growth, margins and returns on capital, high and increasing debt, accounts receivable and inventory, and weak competitive advantages - all at a ridiculously high price.

But shorting is not simply the opposite of long investing. It’s much harder and more dangerous for a number of reasons:

1) Your upside is capped and your downside is unlimited - precisely the opposite of long investing. When shorting stocks, you could be right 80% of the time, but the losses from the 20% of the time that you’re wrong could exceed the accumulated profits. Worse yet, a once-a-century storm such as the Internet bubble might wipe you out entirely. If there’s even a 1% annual risk of such an event, there’s a 40% chance of it happening over 50 years (and 63% over 100 years).

2) To prevent such an occurrence, most short sellers use stop loss limits, meaning they will start covering the short if it runs against them a certain amount. This means short sellers not only have to be right about a stock but also about the timing. If a stock rises significantly, many short sellers will be forced to lock in losses, even if they are later proven correct.

3) In order to short a stock, you first must get the borrow from your broker, who has the power to call in the stock you’ve borrowed at any time - or, worse yet, buy stock to cover for you. Brokers are most likely to do these things if the stock is rising quickly, and they’re probably doing it to other short sellers as well at the same time, so all of this buying pressure can cause a stock to rise even further, triggering even more covering. This vicious cycle is called a “short squeeze” and it isn’t pretty - I can show you the scars on my back.

4) Shorting has gotten much more competitive. There are now thousands of hedge funds (and who knows how many individual investors) looking for the same handful of good short ideas in contrast to a few dozen a couple of decades ago. This results in “crowded” shorts, increasing the odds of a short squeeze.

5) A short squeeze can also be created if the “float” - the number of shares that trade freely - is suddenly reduced. Such a case occurred in October 2008 when Porsche (POAHY), which owned 35% of Volkswagen (VLKAY), unexpectedly disclosed that it had raised its stake in Volkswagen to 74.1% through the use of derivatives. The German state of Lower Saxony, where Volkswagen is based, owns 20%, so that left a float of only about 5% of VW shares on the market. The short interest in VW was 13%, so moments after Porsche announced its higher stake, the mother of all short squeezes ensued and the stock instantly quintupled from $200 to over $1,000, momentarily making VW the most valuable company in the world. This was extraordinarily painful for many shorts.

6) Short sellers used to earn interest on the cash they held while they were short a stock, but this has disappeared due to low interest rates - and brokers even charge “negative rebates” on hard-to-borrow stocks, meaning that short sellers have to pay 5%, 10%, 15% or more in annual interest to get the borrow.

7) The long-term upward trend of the market works against you.

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8) Gains are taxed at the highest, short-term rate.

9) Shorting generally requires many more investment decisions, thereby increasing the chances of making a serious mistake.

10) It’s a short-term, high-stress, trading-oriented style of investing that requires constant oversight. For most investors, time is their most precious commodity - and shorting can suck up a lot of it.

11) Mistakes become more and more painful as they run against you, since a rising stock on the short side becomes a larger percentage of your portfolio. In contrast, if you make a mistake with a long position, it becomes a smaller percentage of your portfolio as it drops.

12) If you go public with your short thesis, a company can attack you in many ways: file a lawsuit (Fairfax (FRFHF)), complain to regulators (who occasionally investigate) (MBIA (MBI), Farmer Mac (AGM)), tap your phone (Allied Capital (AFC)), etc. Also, expect to get flamed on message boards and in the media. Many people view short selling as evil and un-American.

For all of these reasons, I think shorting stocks is a very bad idea for most investors.

There are, however, nine reasons why I shorted stocks - and why I think it makes sense for certain investors - which I’ll cover in my next article.

This article is published with permission of the author and was originally published on Seeking Alpha.

DISCLOSURE: The author has no positions in any stocks mentioned, is not receiving compensation for the article. He has no business relationship with any company whose stock is mentioned in this article.

The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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