When Shorting, Know All the Costs

As a turnaround investor, one of my constant companions is the short-seller. Turnaround stocks are tinged by negativity, so it naturally follows that they will often have a sizable short position.

"Going short" has become an increasingly popular strategy in the wake of the record-setting three-year bear market that began in March 2000. Investors should be careful, though. It's not nearly as easy to go short, or as inexpensive, as you might think, and the costs facing shorts are much higher than the costs incurred by long-term buy-and-hold investors.

Pay the 'Short Tax'

The cost drag of having a short portfolio is significant. I call it the "short tax," and the tax includes, for example, the reimbursement of dividends. If you borrow stock from a broker in order to short struggling companies like Coca-Cola (KO - commentary - Cramer's Take), which has a 2.5% dividend yield, or Eastman Kodak (EK - commentary - Cramer's Take), which has a 1.6% dividend yield, you'll have to reimburse the lending broker for lost dividend income. To quickly explain this phenomenon, when you borrow stock from a broker, the broker must be reimbursed dividends because those shares have been taken out of an investor's account. (The investor is in no danger as the broker has to back up the loan if something goes wrong.)

The short tax also includes margin interest, which is owed to the lending broker for the stock that you borrow. Transaction costs are also an important component of the short tax. Trades can be executed for $10 or less, but that is not the only transaction cost. Investors lose money because of slippage -- the spread between the bid and ask quote. And if you are short, you lose twice, of course, since you have two transactions -- the short sale and the subsequent buy to cover.

Betting Against the House

Shorts face another burden just as onerous as the short tax, and it's based on the fact that they're betting against the house. By "betting against the house" I mean that over the long haul, the market is headed up -- by about 7% per year on historical average. Look at five-year rolling data and you'll quickly see this "up bias." Only at rare secular peaks do stocks lose money over a five-year period (roughly once every 25-30 years).

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At time of publication, Alsin and/or ACM was long Eastman Kodak, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail].