#$bearx

Short selling sounds sexy. Uncovering accounting fraud or identifying companies promoting faddish products or services can be exciting. But short selling is often an unprofitable and frustrating activity, best left to institutional investors. Most ‘professional’ short sellers have produced awful results. The $110M AUM Federated Prudent Bear fund is down 75 percent over the last 18 years. The $186M AUM Grizzly short fund is down 90 percent since 2000. And famous New York short seller Jim Chanos’ Kynikos short fund has reportedly turned $1 into a dime since its inception.  

The population of dedicated short sellers has steadily declined during my three decades in money management. Most, if not all, delivered disappointing performance, lost assets, and closed shop. Some claim that, despite losing money, they generated ‘alpha’ because their funds declined less than the indexes advanced. This is like bragging about finishing second-to-last in a game of Russian roulette where there are five bullets in a six shooter. You may have lasted longer than the average participant, but you are still dead.  

Today, many managers are shorting index funds and ETFs to claim their funds are market neutral. Why do they do this? To justify charging a performance fee without doing the intensive research required to identify and profit from winning short investments. Because the best short ideas almost always have market capitalizations below $200M—and have minimal trading liquidity—asset managers with excessive AUM cannot make meaningful short bets in troubled, often low priced stocks where the risk-reward ratio is on the side of short sellers.

Given the difficulty and risks, individual investors are advised to avoid shorting. But identifying stocks that are likely to decline—possibly to zero—can provide insights into stocks all investors should avoid owning. Simply put, the best stocks to short are the worst stocks to buy. This might seem like a blatantly obvious statement, but folks consistently buy stocks they would be better off shorting and short stocks they’d be better off buying. Here are a few reasons why this happens:

1) A fixation on being “early”

As I have repeatedly warned, buying low-priced (sub-$5 stocks) and/or the stocks of money losing companies are terrible ideas. If a stock is trading in the single digits, that is almost always a clear indication that something is seriously wrong. The vast majority of these low-priced losers never recover—and the small fraction of troubled companies that do manage to turn themselves around are almost always better buys once their stocks cross back into double digits. That momentum shows that the market has begun to taken notice of the recovery, which almost always leads to greater momentum to the upside.

Conversely, formerly high-flying stocks that begin to decline are almost always better shorts once they lose half their peak value or more (preferably a lot more). Shorting a stock before it hits this point on the downside is extremely dangerous, especially when the company in question is still profitable.

One of the few short positions I’ve written about publicly offers a perfect example of the dangers of shorting a company too early. A few years ago, Intuitive Surgical posted a few bad quarters and its stock dropped from the high-$500s into the low-$400 range. As I made clear at the time, I knew Intuitive was (and still is) a great company with smart management, but I believed declining prostate surgery procedures and slowing sales of its robotic surgery device would bring its still high price-to-earnings multiple down closer to the S&P 500 average. So much for that idea. As anyone who has followed Intuitive can tell you, growth picked up again and the stock followed suit. This week it crossed $800 for the first time. Luckily, I recognized my error and covered my position long ago.

2) Overvaluing valuation

Value traps are dangerously seductive. Investors get so caught up in book values, low multiples of earnings or cash flows and other seemingly attractive metrics, they forget that the lifeblood of any successful business is growing revenues. Investing in a company with shrinking revenues is always a risky proposition, no matter how “cheap” its other numbers appear. On the other hand, shorting companies with rapidly growing top lines is a good recipe for going broke. 

For decades, many short sellers have attempted to “pick a top” in richly valued stocks. This rarely happens. What do Tesla and Netflix have in common? Rich valuations and bottle rocket revenue growth. Yes, their stocks are indisputably expensive, almost ludicrously so. Yes, they may eventually collapse. But as long as they keep growing revenues rapidly, they could both easily double again without ever generating profits or free cash flow. Remember John Maynard Keynes’s legendary quote: “The market can stay irrational longer than you can stay solvent.” Market history is full of overvalued companies that remained stubbornly overvalued long after most shorts busted out or cried uncle and covered.

Shorting a stock on valuation alone is an especially bad idea when it comes to established, profitable companies. When I originally wrote about Intuitive Surgical, its stock was selling below 30x earnings. It currently sells at 43x earnings. Shorting it at less than 30x proved to be a bad idea a few years ago. Shorting it at 43x would almost certainly be an even worse idea now.

3) Undervaluing the perils of debt

The best shorts (and worst longs) are usually companies with shrinking (or no) revenues, relatively large negative cash flow from operations, and often excessive debt. As I’ve written before, if a company has public debt, and that debt has a yield to maturity of 15 percent or more, fixed income investors are already pricing in a high likelihood of bankruptcy. And yet, time and time again, I’ve watched the stocks of companies with high-yielding debt remain elevated for long periods of time, sometimes right up until they officially chapter out.

A sobering report shows just how hard it can be.

After a rough start to the new year, a lot of investors might be tempted to buy into “fallen angel” companies at or near all-time lows. They’re not hard to find. In the tech sector, GoPro and Fitbit, two profitable and recently public companies, have taken major hits. GoPro is down 90 percent from its all-time high. Fitbit has lost two-thirds of its peak value. Another sector where investors might be looking to buy low is energy, where scores of service and exploration companies are down 90 percent or more. Established names like Denbury Resources, Forbes Energy, Gastar Exploration, Basic Energy, Bill Barrett, and Ultra Petroleum, among others, have all been creamed, and could seem like bargains.

All I can say is: buyer beware.

As far as GoPro, Fitbit, and other beleaguered tech stocks are concerned, anyone thinking about buying them should ask a basic, but extremely important question: will these companies exist in five years? There is a chance the answer to that question is no. And even if they do survive, how likely is it that they will enjoy a meaningful stock price recovery? The best-case scenario for GoPro and Fitbit could very well be that their stocks trade sideways for the foreseeable future before a larger business acquires them at a modest premium. The worst case? They disappear entirely, wiping out their shareholders.

Energy is an even riskier proposition. All of the companies I named, and many more in the space, are choking on onerous debt loads. The bond markets know this. The high yields on each company’s bonds are strong indicators that many of them will chapter out before the price of oil has a chance to recover.

If you think I’m being overly pessimistic, I recommend an eye-opening 2014 report (PDF) by JP Morgan Asset Management analyst Michael Cembalest titled, “The Agony and the Ecstasy.” Cembalest’s analysis shows that a shocking number of stocks not only go down, they stay down:

Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70 percent plus decline from their peak value. [emphasis added]

Consider that statement for a moment. Over time, four in ten stocks lose almost three quarters of their peak value—and never recover. And that’s not the only grim finding. The median (note: not mean) stock massively underperforms the index:

The return on the median stock since its inception vs. an investment in the Russell 3000 index was -54%

This report should be mandatory reading for both institutional and retail investors. Yet it was hardly mentioned in the financial press after its release. It should also be mandatory reading for short-sellers, because the lessons it imparts are just as valuable on the short-side as the long.

During 25 years managing a long/short fund, I have watched scores of companies file bankruptcy and go to zero. Yet most short-selling funds—maybe all—have terrible track records. Famous New York short seller Jim Chanos’ Kynikos fund is reportedly down over 80 percent since inception. The largest public short-biased fund, Federated’s Prudent Bear Fund (ticker BEARX), is down 75 percent over the last 18 years. Why? Because most short-sellers try to uncover frauds and accounting scandals like Enron and Worldcom—and that is a terrible way to make money.

Finding and profiting from crooked businesses is incredibly hard. For every accounting fraud, many, many more companies simply fail. Restaurant chains Boston Chicken, Chi-Chis, Planet Hollywood and Koo Koo Roo all filed bankruptcy since I started my fund; as did retailers Circuit City, Bombay, Blockbuster, Sharper Image and Kmart. Failure among public technology companies has been widespread, as well. According to Cembalest’s report, energy, information technology, and telecom stocks have the highest failure rates. Since 1980, roughly half of Russell 3000 stocks in these three sectors dropped 70 percent or more from their peak and never recovered.

Looking back, it’s easy to see why most of these stocks lost value. Too bad hindsight isn’t a great investment strategy. Great investors like Warren Buffett take a clear-eyed measure of where a business is likely to wind up several years in the future. What makes this so hard, as Cembalest writes, is the excessive optimism that permeates Wall Street and corporate America:

While the losses on the stocks in our case studies may seem obvious or inevitable with the benefit of hindsight, in all likelihood the company’s management, its board of directors, research analysts, credit rating agencies and its employees all firmly believed in its long term success.