A Short Primer: Introducing 'Short Stories'

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"He who sells what isn't his'n
buys it back or goes to prison."

-- Anonymous Wall Street proverb

Short-selling is no way to make a living.

Even when they're making money -- especially when they're making money -- short-sellers get lots of grief. They're called liars, rumormongers and worse. Indeed, many bulls seem to think of short-selling as almost un-American, a way to get rich off someone else's sorrow.

The battles can get nasty. But many short-sellers would rather face a roomful of longs than the losses they've suffered in the last three years. With the bull market strong, short targets from

Amazon.com

(AMZN) - Get Report

to

America Online

(AOL)

have soared, costing short-sellers untold billions in losses. And with the flow of money into mutual funds as strong as ever, and inflation low and the yield on the 30-year bond below 6%, the bears may be in hiding a while longer before the market turns.

So why are we introducing

Short Stories

, a new feature that will offer a biweekly look at a heavily shorted stock? Why even bother to learn about short-selling?

Lots of reasons. First off, while shorting stocks can be painful in a bull market, it's a useful hedge against a correction (or a crash). Yeah, yeah, we know there's never gonna be another correction, much less a crash. But with the price-to-earnings ratio of the

S&P 500

now above 23 and climbing higher even as earnings estimates for this year show single-digit growth, a little insurance can't hurt.

Remember, too, that even if the overall market never goes down again, there will still be plenty of stocks that do. Ask anyone who owns

Oxford Health Plans

(OXHP)

. Or

Boston Chicken

(BOST)

. Or

Netscape

(NSCP)

. Each stock has been the subject of a furious battle between the shorts and the longs over the last two years. Each time, the shorts were right. Oxford didn't have any idea how much money it was spending. Boston Chicken's accounting was fishy. And

Microsoft

(MSFT) - Get Report

has pounded Netscape into the ground.

Finally, and most importantly, we don't intend this feature to carry water for the shorts. We'll offer both sides of every story, and we expect that the longs will often have a more convincing case. What we want is debate, the kind of debate that will sharpen your analytical skills and help you value all the stocks in your portfolio.

Good short-sellers know how to read a balance sheet. They understand the difference between cash flow and profits. They can spot the little red flags that show problems long before a company's profits turn to losses. And even if you never short a stock, if you consider yourself a serious investor, you should be able to do the same.

* * *

So what exactly is short-selling? The concept is simple. Longs look for undervalued companies and try to buy low, then sell high. Shorts look for overvalued companies -- and try to sell high, then buy low.

The mechanics of a short sale are slightly more complicated. A would-be short-seller must first borrow the stock he wants to short from someone who already owns it. The short-seller can then offer the stock for sale -- in essence creating new shares of stock from which he, not the company, receives the proceeds. For as long as the seller remains short the stock, he's responsible for paying dividends on it.

Eventually, the short-seller hopes to "cover," or repurchase the stock at a much lower price and return it to the borrower. And, of course, the ultimate victory for a short-seller is for the company whose shares he's shorted to file for bankruptcy. In that case the shares will almost certainly be canceled and their value wiped out entirely.

Generally, shorting a stock is as easy as calling your broker and telling her what company you want to sell. Both institutions and individuals regularly lend stock to shorts in return for charging a few hundredths of a percentage point of the value of the stock. Occasionally, demand to short a particular issue rises to a point where the stock becomes "hard to borrow" and lenders can charge much higher commissions for their loans.

Then there's the "squeeze," which can lead to sudden, sharp jumps in price. Lenders can force short-sellers to return the stocks they've borrowed at any time. If that happens, a short must find another lender -- or buy back the stock on the open market. If enough lenders call in their loans at once, there won't be enough stock to go around, and many shorts will have to cover, creating buying pressure that will quickly force up the stock's price.

In turn, the run-up in the stock's price will cause some short-sellers to face "margin calls," forcing them to choose between putting more money in their account or covering their shorts. Inevitably, some of the shorts won't be able to meet their calls and will have to cover, putting further upward pressure on the stock. And that will create even more margin calls, in a vicious circle that doesn't end until only the best-capitalized shorts are left.

Some other details about shorting:

In general, the proceeds from a short sale can't be used by the seller but instead must be left in escrow so the broker handling the sale will know that the seller has enough money to cover the short. In addition, a short-seller must provide an additional cushion in cash or stock of at least 50% of the value of the stock he's shorted in his account, in case the stock rises.

An example: If a seller shorts 100 shares of a $100 stock, he must have a total of $15,000 in his account -- $10,000 from the proceeds of the sale, plus another $5,000 in margin. If the stock rises $10, the seller must add another $1,500 to the account -- because the broker will now require $11,000 to cover the short, and $5,500 more in margin.

Another way to profit from short sales is from the interest paid over time on the proceeds. For example, shorting 500 shares of a $40 stock generates $20,000. Over a year, that pool of cash will earn about $1,000 in interest.

But most retail investors don't have enough clout to get their brokerage firms to hand that money over. Instead, the firms keep it for themselves -- a tidy way to profit from the risk that their investors are taking. If you're seriously considering shorting, try to find a broker who will at least agree to share the interest from the proceeds of the sale with you.