by Martin Zweig
Technically, when you sell short you borrow the securities from a brokerage house and sell them in the market. You owe the broker these securities. For collateral, you deposit a certain amount of required cash with that broker. Since he knows that there’s enough money to repurchase the securities if necessary, there is no time limit. Don’t be concerned about that old saying, “He who sells what isn’t his’n must buy it back or go to prison.” But, sooner or later, all shorts are covered or bought back.
There are at least two good reasons for selling short. If you think it’s a bear market or that a particular stock is on the skids, you can garner good profits by selling short. You may also want to sell short to hedge your portfolio. Let’s say you have a $100,000 portfolio. You think the market will weaken over the next six months but you don’t want to disturb some long-term holdings, perhaps for tax reasons. What you can do is sell short other stocks as a hedge. For example, you own some General Motors on which you’re hoping for a long-term gain. In the short run, you might want to sell short Ford to protect yourself. So for either speculating or hedging, short selling can be very useful.
I personally like to sell short and frequently feel more comfortable on the short side of the market than on the long. But short selling has a bad rap. The average person has a tremendous hangup about selling short. I don’t know why but it exists. In no particular order, here are some of the perceived negatives about short selling, none of which is true.
The first misconception is that short selling is un-American. Somehow it just doesn’t seem like apple pie and the flag to sell short. People perceive it as a bet against the country and that’s just wrong. If you sell short General Motors or AT&T, you’re not betting against the United States. All you’re saying is that at times these stocks may be overvalued. If the stock is worth $50 and it’s selling for $70 or $80, there’s a good chance it may recede to $50 or even $40, especially if it’s a bear market. There’s nothing unethical about that appraisal. It’s just reality—the stock may go down.
Sometimes you may sell a stock short when you feel that the company will go bankrupt. That’s not un-American either. There are thousands and thousands of bankruptcies each year in the U.S. Your selling short is not going to cause any company to go under. All you’re doing is wagering in the stock market that a firm is in trouble. Even if it doesn’t go bust, it may have poor earnings, and the stock may decline. If you profit from your judgment, it’s not different in principle from profiting on the long side when you anticipate that a company’s earnings will increase.
Also, selling short is a very common business practice outside the stock market. They just don’t call it selling short. For example, you go to a car dealer to buy a Chevrolet and you want it with fancy red paint, a stereo, and an automatic seatwarmer. You order all these extras and the dealer says, “I don’t have such a car in stock, so I’ll have to order it for you.” You say, “Okay, that’s fine. Order it.” He says, “I’ll have the car in a month. Pay me a deposit now. We’ll order the car and deliver it to you.” You agree. What’s happened is that the dealer has sold short a car. He has actually sold you something before he’s bought it from the factory.
The second rap on selling short is the belief that your profits are limited and your losses unlimited—and that is absolute nonsense. For example, there is a misconception that if you were to sell short a $50 stock, the most you could earn is $50, or 100% on your investment, if the company were to go bankrupt. Conversely, people believe that if you guess wrong there is no theoretical limit to how much you can lose. The stock could go to 1000, in which case you’re out twentyfold on your money. Such thinking is faulty to say the least.
In the first place, when you sell short you put up collateral with a broker, which can be in the form of Treasury bills if you want to continue earning interest on the money. The minimum collateral is 50% of the transaction. So, if you were to sell short 100 shares of a $50 stock, that’s $5,000, and you’d have to put up at least $2,500 in collateral.
To simplify it, let’s say you put up the whole amount. You place $5,000 in T-bills with a broker. If that stock were to go up, he would eventually call you for more money. By the time the stock rose to $80, you would have a $3,000 loss. Your equity would be down to $2,000. Before that point, the broker would have requested more collateral. If you didn’t put it up, he would cover the sale by buying the stock and you would be out.
The only way you can lose an infinite amount is to keep advancing more and more money, which is like pyramiding your loss. Remember the golden rule, “The trend is your friend. Don’t fight the tape.” If you have a loss like that, get out. Nobody’s holding a gun to your head for more money. Only a fool would keep putting up money on a losing short sale like that.
On the brighter side, your profit potential in a short sale is not limited to 100% profit. It is virtually unlimited. For example, you short 100 shares at $50 and the stock falls to $25. That’s a $2,500 profit for you. If you started with $5,000 in equity, your total equity in the account is now $7,500. At this point the stock is trading at $25, which is $2,500 per 100 shares. To maintain 100% equity behind your position, you only need $2,500 in the account.
You then pyramid (without using margin as such), selling short an additional 200 shares. You now have 300 shares short, which would require the $7,500 backing. If that stock were to go to zero, you’d make an additional $7,500 in profit. So your total profit would be $10,000 on a $5,000 investment, which is 200 percent.
But it doesn’t have to stop there. Suppose the stock then drops from $25 to $10. Now you have 300 shares of a $10 stock. The total capital you need in the account without margin is $3,000. Remember, you have $7,500 in capital. On the drop from $25 to $10 you’ve made 15 points, or $1,500 per hundred shares, which is $4,500 in profit added to your $7,500 equity. That gives you $12,000 of equity when the stock is at 10. You’re only short 300 shares. You could then short another 900 shares at $10 without putting up any more money or without using margin.
Let’s say you did that. Now, at $10 you’re short 1200 shares. What you’re doing is following the tape. You’re shorting more as the stock drops. Now suppose the company goes bankrupt. The stock falls from $10 to zero. You’ve made $12,000 on the drop, but you had an additional $12,000 in the account when the stock was $10. So your total ending equity is $24,000 when the stock is at zero. Since you started at $5,000, you have made almost a fivefold profit. If you want to, you can pyramid a lot more on the way down than in the example. You could short more at $5 or at any other price. So your profit on the downside is virtually unlimited.
Remember, if the stock goes down and you don’t short any more, you have excess equity in the account. If a $50 stock falls to $25, you’ve got $7,500 of equity in the account. Since you need only $2,500, you could take out the extra $5,000 and earn interest on it or do something else with it.
On the other hand, if you are on the long side and the stock goes from $50 to $100, you can’t pull any money out unless you go on margin. Therefore, on the upside you are always pyramiding, because you have to let your money ride all the time. On the short side, to be fully invested you actually have to keep shorting more and more as the stock goes down. People don’t think of that for some reason.
Many investors believe it’s risky to short more on the way down. It really isn’t if you know what you’re doing. If the company is going to go broke, it doesn’t really matter where you short. You’d make just as much money shorting at $5 as you could at $25. Stocks that are already down from $100 to $10 are still pretty good shorts if the stock is going lower. If the stock eventually dips to $2, you can make 80% by shorting at 10, even without pyramiding. If you short it at $100, you’d make 98%. Returns of 80% and 98% are not all that different.
That’s one reason I find shorting very reasonable. If you’re willing to let your money ride, you can make far more than 100% without even using margin. Your loss is not unlimited. The only way it becomes un
limited is if you’re crazy enough to throw more money away in a losing cause. Yes, short selling has a bad rap.
There is a third negative on short selling that is real. After the crash in 1929, the government had to blame somebody. The cause did not rest with the short sellers, but they were a vulnerable target. Attributing the market collapse to the fact that some people sold short, the government decided to make short selling more difficult. That’s why they imposed an uptick requirement. That means that if you’re going to sell short, you have to sell at a price higher than the previous price for listed stocks. That makes it a little harder to get off the short sale, but it doesn’t preclude it.
Additionally, the tax people discriminate against short selling. Even if you hold the short position for more than six months you can never get a long-term capital gain on it. No matter how long you hold the short sale, it will always be considered a short-term gain or loss. However, the alternative might be worse, such as bear market losses or a bear market without your participating on the downside.
Another plus about short selling is that not many people do it. So you have the field relatively to yourself as opposed to participating on the long side.
I also find that negative research on a company is usually superior to positive research. An extensive study covering several years of market activity disclosed that following buy recommendations of brokerage houses was really no better than choosing at random. In other words, on buy recommendations you could do just as well by throwing darts at the stock market page. Sell recommendations are a different story. About three-quarters of them underperformed the market. That is, they went down more than the market. Partly because sell recommendations are so rare, they tend to be better.
Based on personal experience, it’s easier to ferret out negative information. If a company has taken advantage of permissible accounting rules and has overstated earnings, that will catch up with it eventually. Or if a company has a fundamental problem, such as inventory accumulation in the face of declining orders, that will surface sooner or later. Since it’s already in the works, the bad news will get out and the stock will probably decline. If you’re betting on the long side, frequently you’re depending on a prediction that may not work out.
For example, XYZ has a terrific product and forecasters estimate that sales and earnings should grow 20% a year for the next five years. All too often, unexpected competition appears or the economy turns down, and the earnings don’t climb as anticipated. It’s harder for a story on the long side to work out as well as one on the short side. Once the bad news is in the can, it’s there and you can’t get rid of it. Eventually the stock should get hit. That’s why I think playing the short side is easier than the long side. Of course, short selling in the wrong market can kill you. You don’t want to sell short in a bull market unless you are hedging something.
I happen to feel comfortable with short selling, a practice I think is terribly misunderstood, and have written this chapter to clear up some of the misconceptions about this investment strategy. However, at this point I am not recommending that the average investor engage in short selling. I consider it a supplemental strategy for the really sophisticated investor. Perhaps if I write a second book and decide to get a little more complicated, I’ll go into short selling in greater depth.
CHAPTER 15
Questions and Answers on Investing
Why should people with money in certificates of deposit, Treasury bills, or money market funds consider investing in stocks at this time?
From 1966 to 1982, we were in a long-term bear market. The Dow Jones Industrial Average dropped from roughly 1000 to under 800 in about sixteen years while the inflation rate just about tripled. Inflation-adjusted, the Dow slid from about 1000 to, let’s say, 250! As “real,” or inflation-adjusted, prices eroded, the public got turned off and was a seller of stocks—rightfully so, I might add. With other vehicles available at higher yields, a whole generation of investors had not put much of its money into the stock market. Now, however, conditions have changed.
People should consider investing in stocks because stocks offer the highest long-run returns of all the financial instruments. At this writing, yields of CDs and Treasury bills are at relatively low historic levels. This makes investing in these instruments unappetizing. It also makes stocks more attractive. As a result, money has poured into stocks in recent years. But in buying stocks when other yields are low, you should be aware that eventually interest rates will climb and the stock market will become high risk and start to decline.
However, I have no problem with people putting some of their money in the stock market when interest rates are low. Of course, you will have to make adjustments when interest rates start to rise. That’s where the indicators I describe in this book come into play. When the indicators point to higher risk, you should cut back until conditions improve.
Do well-informed individual investors have any advantages over large institutional investors?
Yes. I think that an individual investor, well informed, can beat the pants off institutions because he has tremendous flexibility. If you are running, say, $50,000, your money isn’t going to affect the market. An institution with several billion dollars is like a battleship. It’s very hard to maneuver. You can’t trade. You’re limited in what you can do. You can’t buy meaningful positions in small stocks when you’re that large because you’ll wind up owning the whole company. The little guy might find an over-the-counter stock that trades five thousand shares a day and is a $10 stock. He can buy a couple of thousand shares or even a couple of hundred shares, which could be meaningful. Simply by being more maneuverable, the little guy has a tremendous advantage over institutions.
Are common stocks still a good inflation hedge?
I’m not sure that common stocks were ever a good inflation hedge. Studies have shown that stocks do best during periods of relative price stability. The worst performance for stock prices accompanied extreme deflation during the bear markets of 1920 and the early and late 1930s. The next-worst periods for stocks came during periods when inflation rates reached 8% or 9% or higher.
Investors should consider “real” returns in the stock market rather than nominal returns. If inflation rises 10% during a year and the stock market stays even, you actually lose the equivalent of 10% of your purchasing power. In other words, your dollar would only buy 91 cents’ worth of goods at the end of the year (100 is 10% greater than 91).
Of course, some stocks tend to do well during periods of inflation. These include holdings in extractive industries, such as gold, silver, copper, and oil, as well as timber. The prices of these commodities generally rise faster than their costs, increasing profits and making the stocks more attractive.
Most other industries suffer during times of inflation. Utilities, for example, have dramatically increased fuel costs and don’t have the latitude to raise prices proportionately. Airlines also have a problem with fuel prices. Companies heavily dependent on raw materials and labor find their profits squeezed. The total result is that the market usually does poorly during a heavily inflationary period.
One reason most people have misconceptions about the performance of stocks during inflationary periods is that they compare stock values today with those of, say, fifty years ago and find they have surpassed the inflation rate. That’s faulty logic because, during the subperiods within that fifty-year span, the markets did extremely well during times of price stability and very badly during high inflation. Generally speaking, it’s a myth that stocks provide a good inflation hedge.
How much money do I need to start investing in the stock market?
You don’t need a lot of money, but if you have a small amount—$500 or $1000 or even up to $5000—I suggest that you buy mutual funds rather than stocks.
Which news and information sources do I need if I want to play the market in a fairly serious way?
First, you need one good daily source of general information. Three val
uable sources are the financial section of The New York Times (from which I get a lot of the data I track), The Wall Street Journal, and Investor’s Business Daily. Since most local papers around the country don’t have really adequate financial sections, one of the three above is a must.
For overall data, my most indispensable publication is Barron’s. You can subscribe, but I buy it at the newsstand on Saturday morning. Barron’s is a great source of information of every description, and there really isn’t any newspaper or magazine that is a substitute.
When it comes to specific investment advice, there is a great deal of competition and I would not rely entirely on any one source. From time to time, you may want to consult reference services like Standard & Poor’s, Moody’s, or Value Line. Then there are the stock market newsletters, including my own Zweig Forecast and Zweig Performance Ratings Report. You might even want to read some of the research from brokerage firms—at your own peril. Material from brokers varies from interesting to undistinguished. If you want, you can read an incredible amount of material. I try to limit what I read, otherwise it gets out of hand. However, I do spend a lot of time with statistics and other data from government publications and elsewhere that the general investor would not require.
How should I go about building a modest portfolio for, say, $20,000?
First, you should diversify. When I say diversify, I not only mean with several stocks, but with stocks in different industries. That old adage about not putting all your eggs into one basket really applies to the stock market. It’s too risky. The worst thing in the world is to win the battle and lose the war, the battle being the direction of the market.
Let’s suppose that you turn bullish and the market does indeed go up—but you have put all your money into one stock and it drops. You don’t want that to happen, so you try to diversify. However you don’t want to buy too many stocks, either. The average investor should try to get in the zone of five to eight stocks. With five stocks, you’re talking about $4000 apiece, which may be enough depending on the price of the stock. To get a much better break on commissions, try to buy two hundred shares of a stock rather than a hundred, where possible. If you’re dealing in $15 or $20 stocks you can do it. If you buy a $50 or $60 stock, you’ll have to restrict yourself to a hundred shares or so.
