The Dangers of Selling Short

The hardest thing to do in stock investing is to pick a loser. Think of how the odds are stacked against you. First, over the past 80 years, U.S. stocks have produced an average yearly return ofa little more than 10%. Stocks make money (again, on average) in about three out of every four years. The period since 1994 is typical. Despite the tech-bubble bust, the 9/11 attacks, the 2001 recession, the war in Iraq and the subprime meltdown, Standard & Poor's 500-stock index, a good proxy for the U.S. market, rose in ten years and fell in three. The reason is simple: The economy grows an average of 5% to 6% annually, including inflation, and so do companies that take part in it.

Barely breathing

Second, and more important, finding a stock that is on the verge of a decline is extremely difficult. Because markets are awfully efficient, bad news about a company and its prospects is, in nearly all cases, already built into the price of the stock. For example, Ford Motor lost $5.63 per share for the 12 months ending June 30. That's for a stock that trades at about $8 per share. Yet Ford's price has risen over the past 12 months. Why? Ford may be in trouble, but its prospects seem to be improving.

An even better example, although farther afield, is the Baghdad stock market. Although the situation there may appear miserable on a here-and-now, absolute scale, investors see things improving on a future-focused, relative scale. James Grant wrote in his newsletter, Grant's Interest Rate Observer, in September, "The only thing stronger than the Iraqi currency is the Baghdad stock market." He added: "In January, just 41 listed Iraqi companies attracted any meaningful trading activity." But by the end of July, the figure had jumped to 58, and 42 of them were at all-time highs. In that month alone, the Baghdad market jumped 58% on a volume of 73 billion shares.

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So even if you can identify a business (or a national market) that is rotten today, it's far from certain that you will be able to make money from your insight. The company does not merely have to be bad; the market must also think it will become worse.

In fact, the best way to begin a search for stocks that will decline is to look at what is popular, rather than what is out of favor. Each week, Value Line Investment Survey lists stocks with the highest price-earnings ratios -- based on the research firm's own method of calculating P/E, which includes both past earnings and projections.

At the end of September, when the market's P/E was 18, precious-metals stocks, such as Stillwater Mining and Agnico-Eagle Mines, had P/Es that exceeded 40. Meanwhile, mutual funds that specialize in natural resources were booming. For the year ending September 30, Van Eck Global Hard Assets returned 49%, and Fidelity Select Natural Resources, 53%.

Although a popular stock or sector must eventually come back to earth, there's no telling when the forces of gravity will apply the brakes. The price of builder Pulte Homes doubled between 1995 and 2000, doubled again between 2000 and 2001, and tripled between 2001 and 2005, eventually exceeding $40 a share. Since the start of 2006, however, Pulte has dropped to about $15.

Short selling

The way to make money with a stock that you believe will fall is to sell it short. That means borrowing the stock from someone who already owns it and promising to return the shares sometime in the future. You sell the stock today with the anticipation that you will be able to buy it back at a lower price later.

A popular strategy among professional investors, including many hedge-fund managers, is a long-short strategy that fits into a category called market neutral. Stock pickers find firms within a sector whose prospects are very different and invest on a relative basis. You buy the good stock (go long) and short the bad one (sell short). The amount you make depends on how much the stocks' performances diverge.

For instance, you might think that Motorola is a far better company than Nokia. You buy $10,000 worth of Motorola and short $10,000 worth of Nokia. If Motorola rises 20 percent and Nokia falls 10 percent, you make $3,000 (minus transaction costs). If both stocks fall but Motorola falls less, you also make money. Ditto if both stocks rise but Motorola rises more.

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Think of this technique as picking the winner in a two-horse race. You don't have to guess the speed. Even if the market crashes, as long as Motorola beats Nokia, you succeed.

This approach sounds easier than finding an entire portfolio of stocks that are about to tank, but it's still extremely difficult -- again, because stocks tend to be efficiently priced. (For example, Motorola may be a better company to invest in than Nokia, but its valuation currently reflects that difference: In early October, it carried a P/E of 33, while Nokia's was 18.)

The Enron example

Successful short-sellers thrive by zeroing in on stocks that are misunderstood by the market -- often because managements aren't forthcoming about their firms' true financial condition. The classic case was the assessment of Enron by James Chanos, a short-seller whose research in 2000 and 2001 found that the energy company's return on capital "was a paltry 7% before taxes," as he later told a congressional committee. Chanos also became suspicious of some "related-party transactions" that Enron had reported to the Securities and Exchange Commission and of the abrupt resignation of its chief executive officer, Jeff Skilling. A few months later, Enron's managers admitted to overstating earnings, and the company filed for bankruptcy protection. In a year, the stock fell from about $80 per share to less than a buck.

This game may have become tougher in the age of Sarbanes-Oxley because executives can receive long prison sentences for cooking the books. Still, short-sellers can drive down stock prices -- or try to -- by spreading rumors and planting stories with friendly journalists about a firm's possibly perilous state.

Shorting stocks is a tough way to make a living. If the company you short performs the way the market as a whole has performed for decades, then its share price will rise 10% annually. Thus, after four years, a company that was shorted at $20 is worth about $29, and you've lost about half your investment. Think of playing at a casino where the house take is more than 10% on your bets, and you get the idea.

The best evidence that betting on losing is futile is the performance of mutual funds that specialize in the endeavor. Perhaps the best-known is Prudent Bear fund, with total assets of about $800 million. The fund, founded by Dallas money manager David Tice in 1995, sells short not only the broad market (the S&P 500, Russell 2000 and Nasdaq 100) but also, at last report, about 60 individual stocks. The fund also takes some long positions, with a preference for precious-metals stocks. For the five years ended October 5, Prudent Bear produced an annualized loss of 4.4% -- roughly 20 percentage points worse, per year, than the S&P 500 and an average of eight percentage points per year worse than owning a medium-term U.S. Treasury note.

As dismal as Prudent Bear's numbers are, you have to admire Tice. If he were simply shorting the S&P 500, his shareholders would have lost an annualized 16% over the period -- plus the fund's hefty expense ratio of 1.8%.

A two-fund portfolio

The point of this column is not simply to discourage you from shorting stocks but to emphasize how wonderful the normal, straightforward approach of buying stocks can be. Buy what? Well, the market as a whole is not a bad choice. Vanguard Total Stock Market (symbol VTI), an exchange-traded fund that reflects the performance of all publicly traded U.S. companies, returned an annualized 17% for the five years ended October 5. And iShares MSCI EAFE (EFA), which mimics the Morgan Stanley index for non-U.S. markets, returned 24% annualized. Vanguard's fund carries an expense ratio of just 0.07%; iShares' fund is 0.35%, still a nice deal. You could do a lot worse than splitting your investments 50/50 between the two and staying away from the short side forever.