- Going short is tricky, but it might be wise to do so at some point.
- Even if you have no intention of ever being short, looking from a different perspective might dissuade you from being long dangerous stocks.
- In the end, as always, it all boils down to the risk and reward.
Yesterday, we discussed the reasons why one should go short on a macro level. Today, we are going to dig deeper into what we should look for at a specific company level. In my next article, I’ll discuss why 98% of the population shouldn’t go short and give some examples.
The stupidest thing with investing is to fight the trend.
A few days ago, we discussed how cash keeps piling into ETFs so even if some ETFs look extremely overvalued, going short on them and against the trend might not be the smart thing to do. So the key when going short on something is to either take advantage of the trend, or know when the trend reverts.
Betting against the trend can be very expensive and painful. A trend is mostly created by earnings and news.
Estimating Earnings & Deteriorating Fundamentals
If you can know a company better than most other analysts and estimate that there is a good probability of it missing earnings estimates, it might be a good idea to explore for short opportunities. There is nothing worse for Wall Street than when a company misses earnings because then analysts adjust their long term discounted cash flow models to the new situation. A small miss in earnings or a slower growth rate makes analysts largely adjust their models which often leads to downgrades, financing issues, and other negative news that make a stock a perfect short.
Lower earnings lead to lower fundamentals which consequently deteriorates fundamentals and what ticks analysts is lower guidance. You can check the downgraded stocks on NASDAQ’s web page.
Looking at whether a company is overvalued is tricky because in a market like this one, it’s much more likely that undervalued stocks reach up to the overvalued stock than the opposite. Nevertheless, in combination with other factors, it can help in finding the best short.
An example of an overvalued company is Boeing, but there is much more to look for before going actually short.
When a company has recently gone public, insiders usually have a lock up period where they aren’t allowed to sell stocks. When that period expires and if the management doesn’t have much confidence in what is going on, the pressure on selling increases.
Also, insider activity shows how confident the management is in the long term prospects of the business and value of it.
Accounting is a tricky subject, but sometimes a company can’t hide that something is wrong. When inventories grow without sales growth or account receivables grow inappropriately, we might know that the management is taking much more risk to sell the inventory. Further, looking deeper into accounting issues might make you find fraud. When you manage to find that, you are sitting on the short jack pot.
Debt & Refinancing
In my previous article, I mentioned how interest rates are increasing which will make it much harder for companies to refinance. If this goes in combination with weaker earnings or deteriorating fundamentals, a company might get downgraded by rating agencies which is another great short opportunity.
Negative Sector Trends
Some companies have no power over pricing nor demand so if there is a negative trend in the market, this will inevitably hurt the company somewhere. Some companies have longer term contracts that disguise current trends, but sooner or later it hurts the bottom line.
Available Options & Liquidity
When preparing for a short position, it’s good that the company has liquid options or has a lot of liquidity because even if penny stocks may look attractive to short, there might not be many options to do so or you might get trapped in a short squeeze. Something that helps to avoid a short squeeze is the short interest.
The short interest shows you how much of the shares outstanding are sold short. A higher short interest might indicate that you are already late to the party.
With Shorting, It’s All About Managing Risk
You become a great investor when you understand that whatever you do is about risk, nothing else. This leads you to operate in an environment where the downside is perfectly known and measurable which makes it much easier to compare the potential upside to it.
Only when the reward is much bigger than the risk and there is no big impact on a portfolio if things go wrong should one look for shorts or any kind of investment for that matter.
I don’t think we are in a total short environment yet, but it’s best to be prepared and look for options. In my next article, I will discuss why you shouldn’t go short and give a few examples. You will then see whether going short is something for you or if you’re better off limiting your risks with cash.