Why you should never short-sell stocks
The financial media love when big-time professional investors, such as Bill Ackman or David Einhorn, say they have shorted a stock, because it means there could be open warfare between the investors and the companies.
Shorting, or short-selling, is when an investor borrows shares and immediately sells them, hoping he or she can scoop them up later at a lower price, return them to the lender and pocket the difference.
But shorting is much riskier than buying stocks, or what’s known as taking a long position. When you buy shares of company, you obviously hope they will rise in the short term or over a long period or maybe that they will just provide dividend income.
When you “go long,” your maximum possible loss is 100%, or your entire initial investment. That can happen, for example, if a company goes bankrupt.
But if you have a short position, there’s no limit to how much money you can lose if the shares rise. If the share price increases soon after you place a short position, you could quickly “cover” by buying back the shares and returning them to the investor you borrowed them from. If you’re lucky, you might not lose very much.
But an investor named Joe Campbell was not so lucky when he placed a $37,000 short position on KaloBios Pharmaceuticals Inc., late Wednesday, only to find out on Thursday that the shares had shot up about 800% after Turing Pharmaceuticals CEO Martin Shkreli gained control of a majority of KaloBios’ shares.
Oops. Campbell pleaded for assistance, saying he might have to cash in his and his wife’s 401(k) to cover his position, since his broker was unable to react quickly enough to close out the trade when his account balance was wiped out. But he received little sympathy from other investors, as you can read on his GoFundMe page.
‘Being greedy’
“He obviously had a lot of conviction when he decided to do it,” said Brad Lamensdorf, co-owner and co-manager of the AdvisorShares Ranger Equity Bear.
The AdvisorShares Ranger Equity Bear ETF has about $140 million in assets and typically has 40 to 60 short positions on companies with market capitalizations of at least $1 billion. This is one way for individual investors to short stocks of companies that Lamensdorf and co-manager John Del Vecchio think are headed lower, based on analyses of their financial reports.
“He was just being greedy,” Lamensdorf said of Campbell in an interview Thursday, adding that “concentration kills.”
“He was massively concentrated in a micro-cap, which is another major red flag for any investor,” he said.
George Schultze, founder and CIO of Schultze Asset Management in Purchase, NY, said “it is that kind of uninformed investor that makes a market opportunity for all of us professional investors, not only on the short side, but on the long side.” His company has about $250 million in assets under management.
Schultze said in an interview Thursday that his firm “does a lot of work identifying short candidates.”
“There have been some great shorting opportunities over the years, but it requires a set of special abilities not to be burned, as this retail investor apparently was,” he said of Campbell.
“We inevitably wind up having a huge edge over people like this who put down a lot of capital and walk away. There’s something wrong with this — not knowing what you are doing, with no risk controls at all,” Schultze said.
Due diligence could probably have kept Campbell out of trouble, he added.
Professional ‘shorts’ can identify problems
When a major investor places a short, it can be helpful to other investors. For example, Citron Research published a report on Oct. 21 expressing concerns about Valeant Pharmaceuticals International Inc. and its accounting of relationships with specialty pharmacies, including Philidor. Citron Research editor Andrew Left confirmed on CNBC that he had shorted Valeant’s stock.
After Valeant’s predictable denial of any accounting problems with subsidiaries, the two largest US health-benefits managers stopped doing business with Philidor. Then on Oct. 30, Valeant said it was “severing all ties” with Philidor.
Philidor, in turn, said on Nov. 2 that it would shut down.
Valeant’s stock has plunged 29% since Oct. 21. The shares rose 16% on Thursday after Bill Ackman’s Pershing Square disclosed it had built a 24.5% stake in Valeant.
Another well-known short is Whitney Tilson of Tilson Funds, who has issued a seemingly endless stream of comments on Lumber Liquidators Holdings Inc. this year.
A bold short is the one placed on Apple Inc. by Doug Kass, president of Seabreeze Partners Management, who thinks slowing sales and profit growth will lead to a lower valuation for the stock.
When a well-known investor announces a short position, it does not mean you should necessarily follow suit. The investor is likely to be maintaining a diversified portfolio, and may not be “betting the farm” on the trade. The professional short investor also may have access to technical and financial analysis that you do not.
If a known money manager is short a stock you are interested in, or holding, at least do additional research on your own.
Meanwhile, unless you are a professional money manager who has built up sufficient expertise through years of study to play the game, stick with long positions for your investments.