Investing

Our Favorite Short Sales

Our biggest negative bet is against housing, which will remain troubled for some time.

Short selling is a subject that engenders passionate debate. When you short a stock, you're betting that it will decline. Some people view short selling as something akin to flag burning. It's un-American to hope that a company stumbles and its stock plunges, right? Some people even blame shorts for bringing down entire companies, such as Bear Stearns and Lehman Brothers.

Although there have been occasional cases in which short sellers behaved badly—just as there have been (many more) cases in which promoters fraudulently pumped up share prices—we believe most of the arguments against shorting are nonsense. Just as a healthy legal system needs both defense attorneys and prosecutors, healthy financial markets need people who will look at companies in a skeptical light, given that executives, accountants and Wall Street analysts have such strong incentives to spin a positive story.

The Basics

To short a stock, you borrow a certain number of shares and then sell them. You keep the cash, but you must eventually return the stock you borrowed to the lender. Your hope is that the stock declines so that you can buy it back at a lower price, return the shares and then pocket the difference between the price at which you originally sold and the price at which you bought the shares back.

Shorting is not for everyone; we'd argue that it's much harder and more dangerous than investing on the long side (that is, buying a stock the traditional way). For one thing, shorting is a high-stress, trading-oriented style of investing that requires constant oversight. It's also tax-inefficient because gains are always taxed at high, short-term rates. Finally, while your maximum potential gain is the amount of your initial sale (if the stock goes to zero), your downside is unlimited if the stock continues to rise.

We focus on classic value investing on the long side, but we also remain committed short sellers for two primary reasons. The first is simple: We believe it's a moneymaking opportunity. The market often overvalues certain companies, and we can profit when their valuations return to earth. In addition, shorting remains an excellent tool for hedging against risk—particularly in a market trading at a 20% premium to historical valuation levels despite significant areas of concern, such as the housing market and sovereign debt risk. We're able to invest with even greater conviction in promising companies if we're able to hedge our portfolio against broad-based market and economic declines.

Our ideas for shorting today fall into relatively typical categories: wildly hyped companies, such as InterOil (symbol IOC), an energy producer that operates mainly in Papua New Guinea; good companies with spectacularly overvalued stocks, such as Netflix (NFLX) and LuluLemon Athletica (LULU); and companies with decaying business fundamentals, such as Garmin (GRMN) and Pre-Paid Legal Services (PPD).

Our biggest negative bet is against homebuilders, a view we are expressing in part by shorting iShares Dow Jones US Home Construction ETF (ITB), an exchange-traded fund. We believe that the housing market will remain troubled for some time, thanks mainly to nearly eight million homeowners not paying their mortgages. If we're lucky, most of those delinquent mortgages will be renegotiated and the owners will remain in their homes. But under almost any reasonable scenario, a few million of those homes will be sold, many after foreclosure, creating a significant amount of inventory to compete against new homes. We expect little need for new homes in the U.S. for at least a couple of years, so it's hard for us to see how builders can fare well. The same goes for their stocks, which have rebounded from their lows of early 2009, seemingly based on the hope of a strong recovery that we just don't think is in the offing. (For more on the housing market, see Kiplinger’s economic outlook.)

Columnists Whitney Tilson and John Heins co-edit Value Investor Insight and SuperInvestor Insight. Funds co-managed by Tilson are short all the securities mentioned above.

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