The Case for Short-Selling

Editor's note: This column by Doug Kass is a special bonus for TheStreet.com and RealMoney readers. It first appeared on Street Insight on May 15 at 9:34 a.m. EDT. To sign up for Street Insight, where you can read Doug Kass' commentary in real time, please click here.

Many investors have a general misapprehension about short-selling.

They shouldn't.

When done conservatively and with risk controls in place, it is a fertile strategy for successful hedging and for the generation of absolute returns in most market settings.

In fact, short-selling and hedging are a growing necessity in an uncertain world, especially in a more lumpy and uneven period of economic growth that is likely to follow the stock market bubble's piercing, and after four years of unprecedented fiscal and monetary stimulation.

Still, there are the skeptics.

Many consider short-selling a mug's game for a couple of reasons:

1. The gravitational pull (higher) of equities over extended periods of time (about an 8% annual rate of return).

2. The asymmetric risk/reward of a short -- one can make "only" a maximum return of 100% (in a bankruptcy), but an infinite risk is apparent on the upside.

As well, many short-sellers have been decimated in rising markets because they have concentrated on heavily shorted (and speculative) equities and demonstrated little discipline in limiting losses. Moreover, some of those short-sellers have shorted on the basis of conceptual or valuation issues, the timing of which is inherently uncertain, and the market outcome has been consistently poor.

To put short-selling into perspective, of all the hedge fund asset classes, short-selling is the least populated and most underserved. By definition, this provides a unique opportunity to generate excess returns. The entire dedicated short pool in the U.S. is estimated at less than $5 billion, or about only 6% of the size of the Fidelity Magellan Fund.

Despite the influence of New York Attorney General Eliot Spitzer's attempts to regulate Wall Street research, the analytical output of Wall Street is still dominated by purchase recommendations. Wall Street exists for a purpose: not to produce disinterested research but to raise capital for a growing America by selling stocks and bonds. (The higher the market rises, the easier it has been to sell, but the more disingenuous the sales pitch becomes!)

Market participants want to look on the bright side. Individual and institutional investors and the management of the corporations are invariably biased and bullish. How else to explain that nearly every money manager interviewed in the media is constructive? Consider whether you have ever witnessed an interview with a corporate executive who was bearish on the future of his company.

In my numerous appearances on CNBC's "Squawk Box" and in other venues, I have never encountered such an animal. (This is one of the reasons I rarely visit corporate managers in assessing a company's outlook.)