Profiting from Falling Stocks:Short Selling Techniques

Chris Argyrople, CFAConcentric Investments

Mechanics of Short Selling

• Crystal Ball says stock is going to drop, how do you profit?

• Answer: Sell the stock “short” before you buy it, then re-purchase the stock later at a lower price

• How do you sell something that you don’t own?

Short Sale Mechanics

Short Seller of IBM Owner of IBM

Lends IBM SharesBuy Stock GetsBack Later Returns Shares Purchased Extra Income

Sells Borrowed Gets Cash Note: Short Sellers Collateralize

Stock in Market for Selling Shares the Shares Borrowed

Benefits & Risks of Shorting

Benefits:• Can Profit from a Stock Price’s Fall• Sell Stock, earning Interest Income

(because you invest cash from sale)Risks:• Borrow can be re-called at any time• No Limit to How High Stock Can Rise

Long vs. Short Portfolio Mechanics

LONG: SHORT:

10% Opening 10% Opening

Neg. 50% 5% Weight 15% Weight

“Double Down” 10% Weight 30% Weight

Neg. 50% 5% Weight 45% Weight

Total Loss Lose 10% Lose 20%

Risk Controls on Short Side

Due to “Double Down” Problem, Shorting is Approximately Twice as Risky as Equivalent Long Strategy

Possible Risk Management Strategies:

1. Mechanical Method: Cover if you Lose a Set Amount Like 30%

2. Completely Diversify & Wait for your “Event”

Idea Generation on Short Side

Areas Over-Financed by Wall Street• In the Markets, the “Promoters” always win

•Venture Capitalists, I-Bankers, Brokers•Company Management, Other Insiders

• Past Fads: •Bagel Shops (Entry Barriers??, Theme

Restaurants (Rainforest, Planet Hollywood)•Fuel Cells, Golf Companies, Roll-Ups, Linux• Internet: Browsers, Push Computing, B2C, B2B•Satellites, etc.

Idea Generation on Short Side

Possible Screening Tools:• High Short Interest (Barron’s etc.)• Huge Increase in Stock Price• Insider Selling• CNBC Factor: All Your Friends Talk About

It• Valuations

• Momentum Crowd: Janus, Pilgrim Baxter etc.

Characteristics of Good Shorts

Good Shorts = Opposite of Good Longs:• Bad Business Model (Give Product Out

Free)• High Debt Loads• Deteriorating Fundamentals (Fading)• Shrinking Fundamentals (Down Results)• Valuations with Room on Downside• Accounting Issues• Bogus Management

Timing on Short Side

Pay Attention to:• Is Stock Price Rolling Over• Cockroach Theory: Are Other Firms in

Industry Blowing Up?• Changes in Accounting Policy• Insider Selling• Float• Lockup Expirations

Timing on Short Side

Don’t Short on Valuation Alone:• Valuation is a Necessary but not

Sufficient Condition for a Short Sale• Example: Short Amazon at $4 billion

Market Value – the Stock Peaked above $30 billion

• What will spur a Change in Valuation?

Technical Indicators

Timing Hints:• How Does the Stock Do on Huge Down

Days in the Dow or NASDAQ?• If it is Strong, what is that telling you?

• Look for Changes in Investor Sentiment• Example: Amazon Investors Changing

Focus from Revenues to Profits

Tax Issues in Shorting

Shorts are Always Short Term Gains:• Short Term Gains are 35% Federal Rate

(for top taxrate) PLUS 12% Massachusetts• Holding Period Doesn’t Matter

• Don’t Cover “Busted Short” – they never resurrect themselves from the dead

• Consider Tax Breakeven & Portfolio Impacts

Short Squeezes

What is a “Short Squeeze”?• Large Percentage of Open Interest is

Short • Short Term: Buyers Overwhelm Sellers

How & Why: • Short Covering – Mechanical Risk Control• Long Holders Recall Borrows to Squeeze

Takeover Possiblities

Always Evaluate Potential Takeovers:

• What is the Risk that your Stock can be Acquired?

• Look at Potential Suitors

• Example: Didn’t Short Corel because RedHat had $20 billion market cap, an operating system, and no applications software

Chatrooms

Should you Pay Attention to “the Chat”:

• There may be good info in Chatrooms as Short Sellers post info to disseminate bad news

• Be Careful, but there can be good info

Good Books & Sources

• Financial Shenanigans: Howard Schilit• Asencio.com

Read Into Wall Street

Sell Side Analysts Provide Hints:• Examples:• “Peoplesoft priced for perfection”• We initiate XXXX with a strong buy, at

15X 2005 revenue• Conservatively discounted back @

15%• Initiate with a Hold Rating

The Press Release Machine

Too Many Press Releases are Bad:• Be wary when Investor Relations keeps

telling you about the next press release• RedHat: 3 press releases / day for months• RedHat: one time they released the

names of 8 programmers on one of their teams

• Is the Culture Dependent on Press Releases?

Investor Relations & Stock Promoters

Pay Attention to the Company’s IR:• Legitimate Investor Relations Firms:

Morgan Walke, Financial Relations Board

• Morgan Walke doesn’t take options

• Stock Promoters: Get a List of ALL of the companies they have represented

• How many options do they have?• Example: Liviakis Financial – Agribiotech

Unproven Concept Stocks

Don’t Bite their “Hook”:• Needle-less Injection Systems • The Hook: Needle Market is $ Billions• Hook #2: Every Diabetic Will Switch• This company has no competition OR

they are the market leader

Reality:• Research will show tons of competitors• How will they Sell it ?

Beware of Laser Companies

Point the laser at:• Hair: if it grows, then it is a hair

removal laser• Paint: if it peels, then it is a paint

peeling laser• Skin: if it peels, then it removes

wrinkles

Chantal Pharmaceuticals

Chantal Burnison, Founder:• A Doctor• Partner in a Major LA Law Firm• Invented a Skin Cream that Reversed

the Aging Process• Has Patents (costs $6 to pull a patent)• Stock went from $1 to $20• 32 Years Old• Smoking Hot Appearance

Canada & Vancouver

Be Extra Careful with Canadian Stocks:

• Bre-X: Discovered Diamonds in Asia• Can’t Really Verify this Independently• Chief Scientist Fell out of a Helicopter,

BY ACCIDENT• Stock was Still Above $10

Pay attention to the variable that matters: is it the Diamonds or the Helicopter?

Sources of Future Frauds

• Mining Companies Internet Gambling

• Cancer Cures Rollups & Acquis.• Aids Cures• Bio-Terrorism • Bandwidth• New Operating Systems• Encryption• Energy – this could be a big one

There’s Always a Story

• Bre-X: Diamonds in Asia• Molten Metal: Neutralizes Nuclear Waste• Safe Sciences: Cures Cancer• Kendall Square Research: Supercomputers• Biopure: Blood Substitute• Agribiotech: Seeds• PlugPower: Fuel Cells

Pattern? Public Shareholders Get in “EARLY”

Check Out Management’s Past

• Where have they been?• What happened to the stock price?• Did they sell before they left?• Why did they leave ?• Who are they friends with?

• Try to get their “life’s story” – this is generally not scripted

Short Rebate a Function of Fed Funds Rate

• In 2001, Fed Funds rate was 6%, so there was a significant short rebate

• By 2003, Fed Funds rate dropped to 1%, leaving no room for a short rebate