Selling Short

Long-term investors typically don't use a lot of short selling in their strategy. The reason is simple: investing is about being lazy, letting the investment work for you, and about the long-term. While going long doesn't require that one ever sell -- in fact, if one goes for solid dividends payers, then holding on forever is the master plan -- short selling requires that at some point one reverses course and buys back to cover.

However, that doesn't mean that savvy investors can't use short selling as a way to enhance returns, especially if one follows a few rules.

Short Term

Selling short shouldn't be fire and forget. It requires some more work, because at some point one needs to buy it back -- unless, of course, the company is going for total bankruptcy, which is great if you can spot that before everyone else. But typically, you want to get out of the investment before then, to avoid surprises such as delisting and trade halts which could mean you're still responsible for buying back at some point, but now you don't know when.

So, sticking to a few months is probably best and will help you sleep at night.

Margin of Safety

As with going long, in short selling one should require a margin of safety. The price of the security must be so unbelievably high compared to its value that the situation becomes unsustainable in the long run.

How much is enough? That's up to the investor to figure out, but I start with a minimum of 100% -- twice my estimated value. That's because smaller variations could still be errors in my calculation or simply a sustainable premium the market pays for some securities, which can be unlikely to revert to my estimated value in the short run.

Debt Laden

A company that has a lot of debt can quickly get into trouble. Of course, debt doesn't guarantee a company's performance will turn sour -- debt magnifies the positive side too -- but to be a candidate for shorting on my list, it must have a lot of debt. The reason is that debt-free or low-debt-to-equity companies can always fire staff, sell assets or stop producing and reorganize without having creditors go knocking on their doors.

Debt forces interest payment which forces a company to scramble to find revenues. Pressure from creditors during bad times can be a killer. So look for companies with high-debt-to-equity, especially if it's tied with the next two criterias.

Asset Intensive

A company that requires heavy investments of capital to make money can be a terrible investment. Companies such as airlines and some manufacturers that need to constantly renew their assets tend to need a lot of external capital to grow which typically comes from straight debt or dilutive equity offerings. Either way these companies are good starting targets. But that alone doesn't make a company a short candidate; it only makes it a harder job for management.

Poor Management

This is probably the most important reason to sell a security short. And it can also be the hardest one to evaluate. Poor management is the quickest way to lead a company to financial ruin.

I have talked before about how to judge a company's management objectively. These reasons still apply. Especially important is to pay attention to management's candor. Are the quarterly conference calls short and hurried and lacking in details? Do they get even shorter and more lacking when times are bad? These can be terrible red flags.

Another thing to look out for are lots of related parties transactions. Does management employ services from companies or third parties related to them, such as friends, cousins, parents, children and even spouses? A lot of that can be legitimate, but when you find this sort of thing going on in a bad apple, it's typically a magnifier of problems, so make sure to investigate the SEC disclosures regarding related party transactions. The more, the merrier for the short seller.

Never Use Leverage

This is probably the most important rule a short seller should follow: don't borrow money to short a security. Leverage adds a whole new level of uncertainties that are simply too much risk.

First, leverage means you need to pay interest and interest on short accounts are typically a rip-off. Don't give money to the loan sharks of brokerages. Second, leverage magnifies your mistakes. And it's very easy to make a mistake when going short, because, if you followed the margin of safety rule above, you probably sold a company that the market believes has good prospects (high price to value) and markets can stay irrational longer than you want to keep up with margin calls.

In future posts, I may discuss potential short targets as they appear on my radar. For now, I have no short positions other than a few call and put options, which was the subject of another post.

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