Why Shorting is a Bad Idea

When selling short equities, the investor has pretty much everything working against them. I’ll quickly run through the technical issues before moving on to the more interesting stuff- you can find them on many other websites so I don’t think I’ll need to elaborate much.

  1. You face uncapped potential losses. As a short seller, you are selling a security you don’t own and then purchasing it back, regardless of the increase in price. Brokers try to ensure purchasing ability with margin maintenance requirements and many short-sellers use stop-loss caps to buy back shares at prices above the short to stop things from getting out of hand, but if you are willing to keep your position open, the losses are uncapped. There are horror stories in which prices have jumped dramatically in very short periods of time, leaving investors owing brokers many multiples of their initial position. Since you are playing with borrowed money, when short-squeezes occur, you may be forced to take whatever execution price is available.

  2. You have to pay dividends on the shares, interest charges for borrowing them, as well as interest on your broker margin. For stocks in popular short-demand, the interest charges can be exorbitant. Before Sears Holdings filed for chapter 11, interest charges were in some cases above 60% P.A., making a short position likely worthless. It is nearly impossible to achieve above-average returns buying popular stocks, and similarly the interest charges on popularly shorted stocks will likely make shorting them unprofitable.

  3. Your maximum profit is 100% (less any dividends, borrowing fees, and margin interest), and again, if a company is likely to go bankrupt in which case you could achieve nearly an 100% profit from shorting, the borrowing fees may destroy the profit.

When you purchase a stock, you now have ownership of (oftentimes) an income producing asset, or one which you hope will eventually generate income. In shorting you are placing a bet against the asset. If the price of a company you own declines, it doesn’t matter much and you can load up on more shares if you choose for a higher return. If you are wrong about the company and have overvalued it, you will achieve lower than expected profits- though in the long run you will nearly always achieve a positive return as long as the company generates a profit. In the worst case, the company you own suffers losses and declines in value, in which case that position will shrink as a percentage of your portfolio.

When shorting, if the stock price rises, it becomes an ever larger percentage of your portfolio. If you are wrong, you have become more wrong and it will further impact your returns negatively. If you are right but the stock price is just acting weirdly, you may be forced to increase your invested funds to meet maintenance requirements. While an owner of a company can increase their position at a lower cost per share if the price drops, the short-seller has a higher cost per share as the price rises against them.

If you have infinite funds and patience, and if you are sure you are correct, you can simply keep increasing your position as the price rises as a short-seller, but generally you don’t and can’t. Theoretically as a short-seller a rising price can be helpful because you have a more profitable short as long as you can invest more, but in practice you will nearly always be limited by time and funds, and of course the fact that you may just be wrong. This is why stop-losses aren’t a helpful solution to the fact that your losses are uncapped. If you just put a cap on all of your shorts, you will often be exiting positions when they have become the most profitable to you and when they have gained a larger percentage of your portfolio, and you will be taking realized losses. It would be like trying to outperform the market average as a long-only investor but then selling positions as they drop in price- it pretty much defeats the purpose and you will end up in many cases doing the opposite of what you theoretically should be doing.

On the other hand, if you allow positions to swell over time if they move against you, you could have positions far too large for your comfort. In either case, you are probably doing something wrong even if you are right about the valuation- either you are purchasing stock back at a price too high or you have to be comfortable with an increasingly concentrated short position. Again, unlike unrealized losses for stocks you own which may be temporary, if you are forced to buy back stocks on a growing short position, those are real losses no matter how right you are about the price.

The market over time has experienced positive returns because the value of companies on average is always increasing. As a short-seller, this works against your interests. When buying stocks, it helps if they increase in value and similarly, as a short-seller you would want underlying companies to decline in value, as time would be on your side. As stated in previous posts, if you purchase a great company growing organically rapidly, you can pay a pretty wide range of prices and do well over time and even if you pay an absurdly high price, in many cases you will eventually receive positive returns if you hold it long enough.

As a short-seller, this basically precludes you from being able to profitably short an overvalued but rapidly growing company. It doesn’t matter if you are right that a company is dramatically overpriced, if it grows at a rapid pace in the long-term, you will eventually be wrong. For example, if you are right that a company is worth only $10 per share while it is currently priced at $30 per share, if it grows at 25% a year, in 5 years the company will be worth $30 per share (if the stock was priced at $50 for 5x its current value, that would only give you another 2 years).

Popular companies with great potential have a tendency to stay overvalued until they mature, so even in this case if you shorted at $30, the stock could hang around that price for the next 5 years at which point it would be trading at fair value. You would then be in a terrible spot in which you are shorting a great company selling at fair price while having paid 5 years of interest fees on a stock that has remained flat. Worse, the overvaluation could persist while the company grows, growing your position without the valuation gap being eliminated, and after your position has grown the company could eventually grow in value to meet the current price. This would be similar to purchasing a very cheap company but which is taking losses and declining in value by 25% a year. No matter how cheap it may appear, you will eventually be wrong on your position if the losses continue. You may be right that owners will achieve much lower returns than expected if the company is overvalued, but that does not necessarily make it a profitable short position.

When purchasing companies, you would benefit from those increasing in value or at least remaining stable in value, and as a short-seller you would benefit by focusing on companies which are declining in value or at least remaining stable in value.

When shorting, the best companies to short will be those which are going to significantly decline in value over time, and which aren’t priced for that decline yet. They will also be those which aren’t yet popular shorts, so that borrowing charges are reasonable. This obviously is no easy set of features to identify.

Sears Holdings is a company that eventually filed for bankruptcy, and could have certainly been identified to do so years in advance, but the decline started in the early-mid 2000’s, and took about 15 years to finalize. If you shorted back then when borrowing charges were much lower, you still would have experienced a very poor average CAGR despite being correct, given that your max profit is 100% less associated fees. I’m sure there were shorts that did well if they were able to find a reasonable borrowing rate sometime later on, but they still had to deal with numerous short-squeezes as the float collapsed.

If you purchase a good company, it can grow to many multiples of your purchase price and as it grows at a compound rate, its absolute growth grows. If you short a rapidly declining company, its growth in absolute terms declines over time (20% of 100 is much less than 20% of 1000), so the returns as a percentage of your initial investment can decline. This is unlike owning a compounder which will bring about dramatic cumulative returns over time on your initial investment.

If a company is in secular decline and is experiencing declining revenues, fixed charges become a larger and larger percentage of revenues and so without action, losses would increase relative to revenues and the market cap. Management however, is obviously doing its best to work against you by minimizing costs relative to revenues and capable management can neutralize losses. Oftentimes, management will look to sell out prior to any inevitable secular decline and obviously an acquisition would destroy your potential profits. I don’t think it is common that a company is allowed to dwindle down to nothing over time.

Given these potential issues with the large and obvious value-decliners, short-sellers also look for companies which are dealing in fraud or which are run by those acting either criminally or unethically and which have the potential for rapid declines in valuation. There are also opportunities in those which are growing revenues and/or earnings rapidly but are also declining in value. Valeant was an example of both which is why it was a perfect short. At its peak, many reasonable investors could see its debt issuances along with interest charges would likely outstrip future cash flows from its acquisitions (which along with a high valuation was probably more than enough for a good opportunity if you are a contrarian short investor), but along with the Philidor fraud it became a near flawless short position.

There are quite a few companies which exhibit the value-destruction and questionable valuation of the former Valeant, but finding the fraud required a lot of digging by a select few shorts and likely wouldn’t be a repeatable phenomenon in an ongoing short operation. Further, there are many unethical and/or bad managers out there and they are easy to find, but they doesn’t necessarily make for good short opportunities.

From what I’ve seen, the best and least exploited opportunities for short profits would come from the ignored companies which are overvalued and also making poor investments leading to declining value. The short-seller would therefore benefit from overvaluation, reasonable borrowing rates, as well as a company which is declining in value at some rate over time. These would mostly be companies that are making bad investments, racking up debt, have little to no future organic growth potential, and have questionable or at least ineffective management. There are many firms like this and I suspect an investor could rack up many small to medium gains from shorting them without having to worry about rapidly growing positions (and the potential for fair value to eventually reach price) or crazy borrowing charges by shorting companies like Netflix and Sears, respectively.

Just as buying a great company at a reasonable price is difficult, I suspect it would be rare that one could short a rapidly dying company at a reasonable valuation and with reasonable borrowing charges. They may be found on good but meaningless news if prices temporarily jump, but those will likely often be very crowded bets.

Because markets rise over time, the average investor, however unskilled, will in the long-run receive some positive return. I would imagine this is the same reason why the average short-seller will receive losses. For all of the reasons cited above, although it is theoretically possible to run a profitable shorting operation, it is extremely difficult, which is probably why I have never seen a short-only manager beat the market in the long-run.

Short-sellers have the potential to contribute to a vibrant capitalist society by helping to make more efficient security prices, and it is possible they will have a greater impact as well as deliver more value in the future if index funds continue to become increasingly crowded, but for the most part I believe they are swimming against the tide and doing themselves a disservice. Particularly in recent times, many of the better short-sellers have been washed out by rising prices and the inability to retain AUM amid poor performance and growing positions. They have been harmed by both poor bets and poor luck, and I believe in very few cases would a sharp decline in market pricing be worth the years of harm. Unfortunately, I do not believe the complexity and increased risk of shorting has anything to do with sophistication or the advancement of performance, but rather for the mental interest and challenge, less boredom, oftentimes the promotion of one’s ego and in some cases higher fees.