Selling Short: The Challenges Demand a Whole, Active Approach

They say a picture is worth a thousand words, but when it comes to investing, I believe the following chart is worth multiples of that because it highlights the virtues of:

  1. A long-term investing strategy that focuses on finding best-of-breed companies, since a small number of “extreme winners” have historically ended up accounting for the majority of the market’s returns over longer time frames.
  2. Selling positions once you realize your thesis no longer applies, or the company runs into lasting trouble, since two-thirds of all stocks in the Russell 3000 underperformed the index for the 25-year period ending in 2014.
  3. Selling short to profit on declines isn’t nearly the impossible task some make it out to be, since over the same time frame 40% of all stocks had a negative absolute return. But the caveats to this statement regarding shorting are many.

First, take a good look…

As great as this chart is, like everything else in life, it’s not perfect. One flaw is it may prompt investors to conclude that not only is shorting possible, but it’s actually easy to do and something they should get started with right away. After all, if most companies end up losing to the market, then all you have to do in order to generate alpha is short a basket of these stocks and invest the proceeds in an index ETF. Sounds easy, right?

But wait a minute. If we’re going to look at this chart through the eyes of a short seller, we need to keep a few things in mind. For starters, we need to consider the time frame of the study. We all know the famous saying: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Time may arguably be the biggest ally to the long-term investor, but it’s not nearly as friendly to short sellers.

By and large, it simply isn’t practical (or in some cases even possible) to short a stock for multiple years. Unlike buying shares of a stock, shorting results in ongoing expenses in the form of dividend payments (you’re on the hook to pay them to the lender even though you don’t collect any yourself) and you also pay a stock borrow fee. The latter can vary greatly depending on factors including the size of the company, the availability of shares, and demand in the marketplace.

For example, Berkshire Hathaway’s (NYSE: BRK.B) cost to borrow hardly ever budges from 30 basis points (your cost may be differ depending on your broker), whereas Trupanion (Nasdaq: TRUP), a frequent target of short sellers, saw its cost to borrow rise as high as 18% last year. This meant that anyone who was short the stock would need Trupanion to fall by 18% (from their short price) over the course of the following year just to break even if the borrow fee didn’t change.

Often the companies with the most uncertainty regarding the future will have the highest borrowing costs, so odds are what may appear to be a “can’t miss” short already has a high borrowing cost to reflect that view. And because the fees to sell short are ongoing, the longer it takes for your thesis to play out, the farther the stock has to fall for you to make a profit. So, short sellers frequently aren’t afforded the luxury to be as patient for an investment thesis to play out as their buy-and-hold counterparts. Given the fees, a short position is ideally kept open for a minimal amount of time.

However, when you shorten your investing time frame, you’re increasing the odds that your outcome is subject to the market’s randomness (i.e., its “voting machine” tendencies). Unsurprisingly, the performance of the Russell 3000 constituents looks very different when you look at one-month performance since the start of last year. This actually would suggest that the shorter your time frame, the harder it is to find stocks that underperform.

Data Source: Thomson Reuters Eikon, author’s calculations.

But the complications don’t end there. Shorting the stock of a smaller company brings a whole host of additional risks and considerations, including much higher odds of getting stuck in a painful short squeeze, or called out of your position at the worst time. Unfortunately, though, excluding these stocks worsens the odds for the short seller even further. When you remove stocks with a market cap below $250 million from the Russell 3000, the average number of stocks that beat the market in a given month increased by more than a full percentage point for the 13-month period. In other words, during the period measured, the smallest companies in aggregate were more likely to underperform, so you would want to short them even though they have other risks.

Then there is the issue of timing. A common refrain is that the first rule of short selling is to live to fight another day, since in order for you to reap the rewards of all your hard work when a stock finally declines in value, you need to make sure you’re not forced to close your position prematurely. This, too, is harder than it initially sounds since the market is perhaps the best example of the “a rising tide lifts all boats” aphorism. Over the past 13 months, the number of stocks that outperformed the market was actually higher during the months where the market had a positive return. So, a rising market typically helps even more stocks outperform, even those that may not deserve to.

There’s also a big psychological difference when it comes to shorting. Our brains are hardwired to hate uncertainty and the possibility of losses, both of which go hand-in-hand with shorting. In fact, your maximum loss with a single short is theoretically unlimited since there’s no limit on how high a stock can rise. This makes it all too easy for you to begin to doubt your analysis as the stock rises and to close your position prematurely, similar to how people are predisposed to want to sell stocks during bear markets because they fear prices could keep falling. The J.P. Morgan study from which the first chart in our column is sourced has multiple examples where a short seller would need to display nerves of steel in order to not prematurely close a position. For example, take a look at Cisco Systems.

Data Source: Thomson Reuters Eikon, Yahoo Finance.

Those who had the misfortune of shorting the stock in the late 1990s quickly saw the position move sharply against them, and odds are most closed the position before the stock’s massive decline. This highlights another issue with respect to timing: When you short a stock can matter just as much as your thesis. Even if an investor correctly identified the reasons Cisco’s stock would go on to fall 89%, those who shorted Cisco before 1998 were still in the red after Cisco’s massive decline even if you exclude the costs associated with shorting! And shorting Cisco since then has been anything but a slam dunk — the stock has actually outperformed the Russell 3000 since bottoming back in 2002.

At the end of the day, it’s important to remember that there are no free lunches when it comes to investing – on the long or short side. Yes, it is possible to be successful at shorting. However, as Jeff noted in a previous commentary, our experience tells us that shorting requires us to use an active, basket-based approach. And it’s full-time work to manage this basket. Perhaps most important of all, one can never forget that just because they believe a stock is likely to underperform the market over time, it does not mean it will work out to be a great short today, or even over most periods of time. We know it takes a comprehensive and ongoing approach to shorting to make the strategy work, return-wise, on the whole.

—Jonathan (JP) Bennett, CFA

The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues. The mention of specific securities does not constitute a recommendation with respect to these securities. 

A short sale involves a theoretically unlimited risk of an increase in the market price of the security sold short, increasing the cost of buying those securities to cover the short position, and thus a possible unlimited loss.

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