Short Selling - The Pros and Cons

Short selling gets a bad reputation due to the politicized language surrounding the act. You’ll hear critics call it a destructive, anti-American act of market manipulation, but it has the same market impact as selling a stock you already own. Tape readers can’t tell if you’re a short seller or a shareholder selling their shares.

Many prominent investors persuade novices from short selling at all, but there is an appropriate time and place for it in the right market environment and with appropriate portfolio construction. The practice carries some heavy drawbacks on its own, but paired with a long portfolio, it can smooth the volatility of your returns and allow you to take more risk on the long side.

Pro: Easier To Find Low-Quality Companies

I maintain that it’s much easier to find the next Pets.com than the next Amazon.com, especially as an individual investor who doesn’t require the deep liquidity of large-cap stocks. There’s currently between three and four thousand publicly-traded companies on major exchanges in the US. The vast majority of those companies are completely unknown to all investors--retail and institutional, and most are on the lower quality side.

An investor who is willing to do deep due diligence in the hidden corners of the market can find some great short candidates, whether they’re potentially fraudulent companies, technologically obsolete, or just at the bottom of their industry with a poor business model.

Pro: Easier To Find Candidates During a Bull Market

Short sellers perform poorly during bull markets, but if they built a short book of weak companies, they’ll do very well once the cycle changes. The problem does arise where it often takes several years of underperformance before that gratification comes, but that’s where your long book offsets those losses.

During the late phases of a bull market, which is often characterized by speculation, excess, and a lack of regard for valuations, several great short candidates arise. Looking back in recent history, the dot-com bubble created some great opportunities to short-sellers, with unprofitable companies like Webvan, Pets.com, and Flooz.com all trading at ridiculous levels. Of course, you’ll have to weather the volatile price action before the cycle turns, but again, that’s why being long quality companies as well will help.

Pro: Use Short Selling To Get More Long

The great thing about having a long/short portfolio is the uncorrelated returns that your short book provides you. During downturns, where your long book takes a beating, theoretically, your short book full of crummy companies should offset the losses from your longs and then some, because a good short book generally goes down more than the market.

This is exactly the strategy of Jim Chanos, founder of Kynikos Associates, which is 190% long and 90% short. The fund has returned an annualized 28.6% between 1985 and 2017.

Con: Even The Best Lose Money

Jim Chanos is arguably the best short-seller in the world. He runs the “lone short selling hedge fund of any size” and his short fund, Ursus, has lost 0.7% annually since its inception. It’s the rest of his fund, which is 190% long, which generates his superior returns. His short book simply allows him to take more risk on the long side.

Chanos does suffer from an AUM-based restriction, where his fund is too big to meaningfully benefit from the demise of the many shoddy companies at the lowest decile of market capitalization.

Even the best short-sellers breakeven or lose money on their short book on its own. Unfortunately for permabears, being net-short is a generally a losing strategy.

Cons: Stocks Tend To Go Up

This is painfully obvious, but stocks like to go up over time, even the low-quality ones. The rise of passive investing has augmented this phenomenon further. Because so much money is passively allocated throughout a wide range of stocks, even the lowest quality stocks are highly correlated to the performance of the general market, and the general market tends to rise.

Final Thoughts

The main benefit of short selling is that it can provide your portfolio uncorrelated returns to the long part of your portfolio. Of course, there are the structural drawbacks to short selling like the borrowing interest, locating shares, and uncapped risk as well.

When short selling, it’s prudent to keep in mind the quote we’ve all heard countless times: “the market can remain irrational longer than you can stay solvent.”