Investing

How to Sell Stocks Short

Betting against stocks can be a great way to enhance your profits and stay fully invested when times are tough.

One smart way to cope with volatile, unpredictable markets—aside from praying and consuming a lot of single-malt scotch—is to sell stocks short. Many otherwise savvy investors simply don’t, either because they don’t know how or because they fear they’ll end up on the wrong side of a one-time juggernaut like Netflix (symbol NFLX) and lose $60,000 on a $10,000 investment.

I was a little like that before I boned up on the subject four years ago. Shorting helped stanch some of the bleeding in 2008 (I shorted Lehman Brothers, among others). In both 2009 and 2010, I added about 1.75 percentage points to my returns with short selling even though the stock market rose both years. And my shorts were making money this year, even before the market’s summer nose dive.

Granted, many people think short selling is un-American. But shorting can be a great way to enhance your profits and stay fully invested when times are tough.

Spot a Troubled Stock

But don’t ever short a stock merely because you think it is overvalued. I thought cloud computing darling Salesforce.com (CRM) was expensive at $100, when the firm’s CEO was selling shares like crazy. The stock was soon at $160. Instead, wait for a catalyst. Joe DiMenna, of hedge fund Zweig-DiMenna Associates, told Kathryn Staley, author of The Art of Short Selling (Wiley, $70), that he focuses on frauds, hyped stocks, firms in declining industries, and companies that have delivered disappointing earnings or have deteriorating balance sheets.

You don’t have to be a hedge-fund genius to spot some of these problem children. Earlier this year, when frauds were exposed at several Chinese com­panies that had gone public in the U.S., it would have been wise to short a basket of these stocks. I neglected to do so, but I did make a 94% profit in five months shorting Longtop Financial Technologies (LGFTY.PK), a Chinese company that has been accused of falsifying its financial statements.

In 2010, the group to short was for-profit education stocks, a previously coddled industry that the Obama administration was cracking down on. This year, I’ve had considerable success shorting alternative-energy stocks. My thinking is that financially strapped nations will cut back on government subsidies for green energy. I am short First Solar (FSLR) and China’s Trina Solar (TSL), as well as Vestas Wind Systems (VWS.CO), a Danish maker of wind turbines.

I am short Northern Oil & Gas (NOG), an oil-shale play, because I think the stock is overvalued, insiders are selling shares, and the company has engaged in what I believe to be unethical practices. I am also short Gold Resource (GORO), which I think is overstating its gold reserves. Other promising negative signs: Gold Resource insiders have been unloading stock, and three top officials are close relatives. It’s generally a bad sign when a CEO puts multiple relatives on the payroll.

Both the Northern Oil and Gold Resource ideas came from TheStreetSweeper.org, a great free source for selling ideas. You can get ideas from Barron’s, BronteCapital.blogspot.com, the Value Investor Insight newsletter, and Value Investors Club.

My largest short position now is Lender Processing Services (LPS), which helps lenders manage foreclosures. A piñata for the robo-signing scandal, it is being sued by servicer American Home Mortgage. On a conference call, management pooh-poohed the negatives, which led me to increase my short position.

If a CEO bashes short sellers (think Tyco International and Overstock.com), short the stock by the truckload. The best way for a company to hurt short sellers is to deliver great results, not call them manipulative parasites. And one of the best ways to improve your performance is to master the art of short selling.

Columnist Andrew Feinberg manages a New York City–based hedge fund called CJA Partners.

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