In my experience, the cost to borrow shares is a far more powerful predictor than short interest. Anybody who looks at short interest instead of the cost of borrow is probably not that savvy.
Adam Kommel’s (and Wayne Gerard’s) company, aptly named Activist Shorts, is a research service that keeps tabs on free, publicly-available research put out by short sellers. Some of this research is the best research available for a particular stock. Some of these reports expose fraud and act as the catalyst for a stock going to zero. Examples include Muddy Water’s work on Sino-Forest and Jon Carnes’ work on Fab Universal. In those situations, I would say that these short sellers’ reports were the most important document that you could have read for that particular company- more important than the annual report.
There are two parts to Activist Shorts
- The @ActivistShorts Twitter account, which is free. I highly recommend following it. I read it regularly to find out about all the latest reports being released. You can read it for yourself on Twitter and quickly see whether it’s worth a follow.
- A paid subscription service, which can save time if you spend a lot of time following activist shorts (I kind of don’t).
*First see Risks of short selling in practice.
Things I look for:
- Insiders selling massive amounts of shares. Insider selling can sometimes be legitimate as insiders may want to reduce their risk (sometimes this is a BS excuse), support their extravagant materialistic lifestyle, or give money to charity (e.g. Bill Gates and Warren Buffett). Legitimate selling usually occurs slowly and insiders don’t try to dump all their stock in say a single year.
- Insiders are heavily promotional on their stock and project incredible growth, yet they are selling shares. If they know that awesome times are ahead, it makes no sense to sell shares.
- Secondary offerings. A company will sell stock at a huge discount (I call this a fire sale) and pay massive fees to underwriters. Companies will do this if insiders are smart and they know that their shares are overpriced.
On the other hand, underwriters don’t want their clients to get burned all the time. They will promote a stock after a underwriting (the share price will often go up) and they will try to find dumb CEOs who will do secondary offerings when their company is undervalued.
- The company’s profits and numbers are way too high. In commodity-like industries, every company can be expected to make around the same amount of money. Unless the company has some crazy cost advantage or management is incredibly smart, they will be unable to generate incredible profits and extremely high return on assets figures. If they report really good figures, they are probably lying.
- (OTC Bulletin Board / Penny stocks only) There is no actual business. If you read the SEC filings for pump and dump penny stocks, you can see that they spend money on stock promotion and if there is an actual operating business. In promotional materials, promoters have to disclose how much they are getting paid.
Things I don’t put much weight on:
- Aggressive accounting. Such as improperly capitalizing expenses, choosing accounting rules that don’t make economic sense for the business (e.g. capitalizing interest on home communities that aren’t selling), aggressive recognition of revenue and not recognizing expenses right away, any company that reports non-GAAP earnings, etc.Most companies engage in this. But most of these companies don’t strike me as good shorts. And a lot of the really crafty insiders out there will do a good job of concealing their accounting shenanigans.
Things I don’t like to see:
- The underlying business is a high-quality business like RIMM, CRM, NFLX, PCLN. I don’t ever want to short good companies as they can grow 16-20X in the long run.
- Ponzi stocks which continually hold secondary offerings. Yes they are bad companies, but every time they hold a secondary offering the company is actually worth more. The rate of return on shorting these stocks is poor. For example, David Einhorn had a 5% IRR from shorting Allied Capital.
- High borrowing costs. These stocks are crowded by short sellers and ripe for a short squeeze or somebody to engineer a buy-in. On the other hand, this is a characteristic of some really good short selling candidates.
What happens next
While a stock may be overvalued, I don’t want to short it right away. Overvalued stocks can get insanely, unbelievable overvalued. Sometimes this can occur because people start short selling the stock, then they get killed, then they cut their losses and create more buying demand at the top.
I want to be close to the turning point. This usually coincides with the announcement of a secondary offering or an awful earnings release. If a secondary is announced, there is a very good chance that the stock will start going up. Analysts are all slapping a strong buy on the stock, there are crazy rumours about the company being taken over, and devious hedge funds may be buying the stock simply to squeeze the short sellers and force them to cover. So wait for the rally, and then start shorting the stock.
How well does this work?
I don’t really know because I have an extremely small sample size. So don’t take what I say too seriously. Please do your own homework and thinking.
Short selling is a way of betting on stocks going down.
The normal buy/sell process is reversed. You sell a stock and hopefully you buy it back at a lower price. How can you sell something you don’t own? You have to borrow shares from a broker so that you can sell those shares.
Risks of short selling
- Your potential losses are unlimited. You could use stop orders to cap your losses, but stop orders can knock you out of a trade at a loss only to have that trade go in your favour afterwards.
- Crazy stuff can happen. Volkswagen had an infamous short squeeze where the stock went up over 4 times in the middle of a trading day.
- Shorting selling can force your account into a margin call. During this margin call, your broker can liquidate your profit at awful prices. They get to collect commissions and they may trade against you.
- Other people will try to engineer buy-ins. There are hedge funds out there who will buy shares in a heavily shorted company. They will try to drive up the share price, and will yell at an investment bank’s analysts to promote that particular stock (and the investment bank often collects considerable commissions from these hedge funds). Then they will disallow short sellers from borrowing their shares to short. The short sellers must give back their shares that they have borrowed, so a buy-in process ensues. They must buy stock on the open market and return the shares that they borrowed right away… at a significant loss.
- For the obviously awful companies out there, you have to pay a lot of interest to borrow shares to short sell them.
If you short ETFs, note that an ETF can trade well above what its assets are actually worth. This happened to UNG when they said that they would no longer issue creation units (so the risk-free arbitrage on that ETF was no longer available) and the stock traded at a significant premium to its assets, over 10%. There is some obscure ETF which traded at something like 10X what its assets were worth.