If short interest measures the amount of bearish bets against a particular stock, then what are you supposed to do with that data? The answer really depends on your view regarding the research quality of the bears. If you believe the bears have done excellent homework, then it will pay to pile onto the bearish bandwagon and short the stock. There’s just one problem…it’s virtually impossible to know whether the brains of Warren Buffett are leading the shorting brigade, or the boobs of Snookie from Jersey Shore are driving the negative bets.
The situations that I find especially appealing are the cases in which your research conclusions are extremely bullish, yet a large herd of traders have piled up their pessimistic short positions up to the sky in the belief share prices are going lower. These “crowded shorts” provide a large tailwind of buyers – effectively pouring gasoline on the fire – if you are arrogant enough, like me, to believe your bullish thesis will play out. These “short squeezes” occur often when fundamental momentum lasts longer than the bears expect, or when downbeat expectations do not come to fruition. A classic short squeeze occurred when well-known investor Whitney Tilson recently covered his Netflix Inc. (NASDAQ:NFLX) short position (see this article), pushing a high priced stock even higher. Short interest reached almost 13 million shares in September 2010, and declined to a little more than 11 million shares a few weeks ago (compared to about 53 million shares outstanding). Given the stock’s price action, and Tilson’s response, the short interest has likely declined – at least temporarily.
The Challenge of Timing
Shorting is difficult enough with the theoretical unlimited losses hanging over your head, but timing is of the essence too. Often, a short-seller may be correct on their unconstructive view on a particular stock, but the heat in the kitchen gets too hot for them to stick around for the main course. Shorting stocks in a down market can be just as easy as buying in an up market – making money in your shorts in a rising market is that much more difficult.
Rather than follow the herd of short sellers as a trading strategy, I choose to stick with the credo of legendary investor Benjamin Graham, who stated:
“You’re neither right nor wrong because others agree with you. You’re right because your facts and reasoning are right.”
It’s my strong belief the long-term share price of a stock is driven by the sustainable earnings and cash flows of a company. The direction of price and earnings (cash flow) may diverge in the short-run, but in the long-run the relationship between price and profits converges.
The criteria for shorting a stock are just as varied as the factors used to buy a stock, but these are some of the factors I consider when shorting a stock:
- Weak and/or deteriorating market share positioning.
- Excessive leverage – substandard financial positioning.
- Weak cash flow based quality of earnings.
- Management mis-execution and deteriorating fundamentals.
- Expensive valuations on an absolute and relative basis.
A stock is not required to exhibit all these characteristics simultaneously in order to generate a profitable short position, but the framework works for me.
If long investing is your main focus, then I urge you seek out those heavily shorted stocks that maintain attractive growth opportunities at attractive prices. If you are going to seek out rising stocks, you may as well use the assistance of a coiled spring to get you there.
Wade W. Slome is a CFA and CFP® at Sidoxia Capital Management.
Disclosure: Sidoxia Capital Management SCM and some of its clients own certain exchange traded funds and NFLX, but at the time of publishing SCM had no direct position in any other security referenced in this article.
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