Tall task of short selling
Short selling is hard.
If you don't believe it, look at the results of my latest “Short sellers don't have horns” short-selling contest.
Of nine people who entered, only one — Rob Rank, a retired manager in Jensen Beach, Fla. — managed to show a profit.
A short sale is a way of profiting from a stock's decline. The short seller borrows shares and sells them, with the proceeds credited to his account. The proceeds cannot be withdrawn until the short sale is “covered.” To cover a short position, the short seller buys shares to replace the borrowed ones. If the stock falls in the meantime, he profits.
As experienced investors know, choosing a stock that is going to go up is hard. Choosing one that is going to go down is even harder because the stock market rises, on average, 9% to 10% a year. Short sellers must be skillful enough in their selections to buck this trend.
The latest contest was especially tough, as the U.S. stock market (as measured by the Standard & Poor's 500 Index) rose more than 19% during the contest period, which ran from Sept. 28, 2012, through Sept. 10, 2013.
In real life, short sellers confront a second headwind: They must pay interest to borrow a stock. How much interest depends on how scarce is the supply of shares available to borrow. If a company seems to be on the rocks, lots of people want to short the stock, then it becomes a “hard borrow” that can only be obtained by paying a high rate.
The contest won by Rob Rank is the ninth one I have run. I did them each September from 1998-1999 through 2005-2006. Then I dropped them for a while, and revived the contest in a September 2012 column.
Rank won with a short sale on SPDR Barclays Long Treasury Bond ETF, an exchange-traded fund that tracks the return on long-term Treasury bonds. In other words, he bet that Treasury bonds would decline.
That ETF had returned 69% in the five years preceding the contest, as Treasury bonds enjoyed a long rally. But Rank thought, correctly, that the party was over.
“Bonds are today's bubble,” he said. “It is hard to make a case for bonds, even at (the September 2013) level.” He said he might make the same choice in the next short selling contest, which begins late this month.
Juan Martinez, a scientist from central New Jersey, came in second. He picked Sears Holdings Corp. (SHLD) to decline, reasoning that it was “getting killed” by Wal-Mart, Target and Amazon.com. His concern was well placed, but in a rising market, the stock returned 2%.
Third place went to Joe Dolney, a certified public accountant from Harrison City, whose choice was Zynga Inc. (ZNGA), a purveyor of online games. While it did trail far behind the overall market, Zynga managed to return 6%.
This was certainly one of the toughest years ever for contestants in my short-selling. But it is not the worst ever.
In 2002-2003 contestants on average lost 114%, while the S&P returned 24%. The would-be shorts really got their heads handed to them, a reminder of how dangerous short selling can be. A short seller can lose more than the amount initially invested, because there is no limit on how much a stock can rise.
And yet, there were a few years in which the short-sale contestants really cleaned up. In September 2001-September 2002, for example, the shorts emerged (on paper anyway) with a 39 percent profit, while the S&P 500 fell 13 percent
All entries should include six items: (1) your name, (2) your home city, (3) your occupation, (4) your phone number, which is important if I need to interview you, (5) the stock you wish to sell short and (6) the reason you think it will decline.
The stock selected must have a market capitalization of $100 million or more. For purposes of the contest, you do not have to borrow the stock or sell it short with real money.
Entries must be submitted by 4 p.m. Eastern time on Sept. 30, 2013. The contest runs from that date through 4 p.m. on Sept. 12, 2014. Results will be judged by total return, which includes capital gain or loss, and reinvested dividends.
For his success in 2012-13, Rob Rank will receive a CD by the great jazz pianist Bobby Short.
In light of the high risk level of short selling, I suggest that inexperienced investors avoid it altogether. Experienced but nonprofessional investors should limit short sales to no more than 10 percent to 20 percent of their portfolios, and watch the positions closely. Professionals, proceed at your own risk.
John Dorfman is chairman of Thunderstorm Capital LLC in Boston. His firm of its clients may own or trade securities discussed in this column. He can be reached at email@example.com.