If there's an unabashed villain in the eyes of the investment world, it's probably the short-seller. These are the guys who bet against stocks, who prey off the lame and weak. And the weaker the target, the better. "We're about as negative on the outlook for this company's survival, much less business improvement, as we've been on anyone," Boston-based hedge fund manager Neil Druker told Barron's weekly in March.
Druker was gloating about 360networks Inc., soon to be road kill on the telecom highway. 360networks filed for protection from creditors in June. Its stock plunged below 15 cents, compared with highs of more than $35 in last year's tech mania. To short-sellers like Druker, the death spiral was a dream come true.
In the simplest terms, short-sellers bet on failure by borrowing shares that someone else owns and then selling them in the market. They eventually have to replace the borrowed shares. If the share price declines, their profit is the spread between what they sold the shares for and what they pay to cover the short position, less trading costs. But if the price rises, they lose.
As for the question of ethics, there's nothing untoward about playing the short side of the market. Short-sellers in fact help keep the market honest by exposing, and helping to right, its excesses.
For investors who want a taste of the short life, there are three alternatives. You can short stocks yourself. But, for a variety of reasons I'll explain below, shorting can be risky and expensive. You can also make use of options on individual stocks or market indexes. As well, there are hedge funds that take both long and short positions in stocks or market indexes. These funds are probably the best way for most individuals to get started.
There are fewer hedge funds in Canada than in the United States, and most of them are aimed at high- net-worth clients, with a $150,000 minimum investment. However, there are a smattering of products aimed at the retail investor. The @rgentum Canadian Long/Short Equity Portfolio fund is one.
Options called "puts" can be used to simulate short selling. Puts give an investor the right, but not the obligation, to sell a stock at a set price up until some future date. Suppose, in late July, you believed that IBM Corp. was overvalued when it traded around $104 (U.S.) on the New York Stock Exchange. You could have bought January, 2002, $100 puts on IBM for $6.90. They would give you the right to sell IBM shares for $100 any time until the puts expire in the third week of December.
The worst you can do is lose what you paid for the puts. That would be the case if IBM stays above $100, and the puts expire worthless. But if IBM falls far below $100, the value of your puts will jump, and you can sell them at a profit. Even if you want to hang onto your IBM shares, you could buy puts as insurance against a price drop. You can also buy puts on index units, such as those tracking the Standard & Poor's 500, to protect against market declines.
For most retail investors, short selling itself is dangerous. Stocks have tended to rise over the long term. You usually need a strong grasp of accounting as well. Your losses from short selling can also be far greater than proceeds from your original sale: The underlying stock or index could keep rising indefinitely.
If you're still determined to sell short, actually doing it is simple. If you have a full-service broker, just ask. Most discount brokerages will allow you to short sell too, but restrictions apply. Your brokerage firm will lend you the shares. Suppose you short Barrick Gold Corp. because you think that bullion prices are headed lower. You borrow 1,000 shares and sell them at $23 a share (the trading price in late July), for a take of $23,000. Say the stock falls to $18 and you buy back the 1,000 shares for $18,000. Your profit, ignoring fees, is $5,000. But if Barrick shares climb to $30 and you spend $30,000 to buy the stock back, you'll rack up a $7,000 loss.
Brokerages also require you to leave the proceeds of a short sale plus a margin in your account in case the trade goes bad. TD Waterhouse Investor Services requires a 30% margin for option-eligible stocks, which is typical, and 50% otherwise. It also won't allow you to short stocks priced under $3, because of volatility.
It is possible to maintain a short position for a long time, even indefinitely. But, as well as commission on the original sale, you must keep paying dividends to the holder of the stock. If the stock rises substantially, you'll also have to kick in more cash to maintain the margin. In the Barrick example, if the shares climb to $30, the brokerage would ask for another $2,100. Also, the firm may call back all the shares at some point.
Despite the troubles in stock markets this year, there has been just a slight uptick in short selling. "It's not a large [part of our business]" says Corey MacEachern, senior vice-president of retail sales for TD Waterhouse. "Of our order flow it would be approximately about 2%."
If shorting is so risky and costly, why do it? As with options, you can sell short to hedge. There is also the lure of big profits. Plus, there are few people doing it. "It's a loner's game," says Jim Doak, president of Toronto hedge fund Enterprise Capital Management.
As for strategy, the bluntest approach is to make a broad market call -- say, gold or oil prices will collapse -- and short a stock in the appropriate sector. But, at best, your successes will likely be random. Equally boneheaded is assuming that just because a stock has gone up a lot, it has to fall. Professional short-sellers usually look at the valuation of specific companies. "You know some businesses are bad," says Doak. "When they get gussied up in the market, when the stock market is willing to pay a much higher multiple than you as a private citizen, you have to ask yourself, why is that?"
Red flags that Doak looks for include:
Serial-share issuers: companies that issue a torrent of new shares. Celestica Inc., a recent Doak short, is one example. Hyper-issuers that went bad in the past include Laidlaw Inc. and CoolBrands International (formerly Yogen Früz World-Wide Inc.).
Excessive bullishness: If you can paper a barn door with strong "buy" recommendations, it's possible the Street has fallen in love with a stock, or the underwriting commissions flowing from the company.
Outrageous claims and massive egos: Any company that says it has invented a new way of running a business probably hasn't. Persistent insider selling may be another good clue.
Short-sellers also look for yellow flags in financial statements. These include a sharp rise in accounts receivable, which means a company is recording revenues it has yet to collect. Another danger indicator is related-party transactions, in which much of a company's sales come from businesses tied to it. Costs booked as capital investments rather than expenses, and a regular parade of one-time charges, are other danger signals.
There are some stocks you probably never want to short, says Doak, including potential takeover targets, as are resource companies with exploration under way.
Beware of momentum as well. High-flying Cott Corp. was a favourite target of the shorts in the early 1990s. Cott's shares eventually sank from nearly $50 to $5. But that was after many shorts were forced out at huge cost by the stock's meteoric rise. Sometimes, being right isn't enough.
Still tempted? Here's a tip from the pros. Start a theoretical short-selling diary. Take your hunches -- better yet, the fruits of arduous investigations -- and commit them to paper. It's a cheaper way to develop the discipline successful short selling requires.
SOLD SHORT
Twice a month, the Toronto Stock Exchange publishes a list of total short positions, by company. Some of those positions aren't true short sales. Stocks may be shorted for many reasons -- often complex hedging or arbitrage strategies are involved. But most other companies appear because many investors are betting their shares are headed lower. Here's a random sample of some heavyweights on a recent list.
Nortel Networks (16.8 million shares sold short)
Bear in mind that's a pretty small total compared to Nortel's 3.2 billion shares outstanding. Still, at least someone has made money during the free fall that has picked millions out of the pockets of Nortel investors.
Celestica (7.5 million shares sold short)
Computer equipment maker hasn't been clobbered by the tech meltdown. But short-sellers are eyeing Celestica's razor-thin margins, ballooning share float and more tech carnage, and they figure Celestica's day -- and theirs -- will come.
Air Canada (6.1 million shares sold short)
Debt-addled airline bleeding red ink stumbles through wrenching turndown as its lunch gets eaten by fleet-footed rivals. The shorts are winning this war. The stock has dropped from more than $20 to around $8 in a year.
360networks (5.0 million shares sold short)
Now in creditor protection, the shorts were dead accurate on this one.
Anderson Exploration (4.6 million shares sold short)
Anderson is weighted to the natural-gas side of the business, which has been hit harder than oil by soft prices.