A Hedgehog Commentary

The Thrill and The Terror of Shorting^* Stock

10/1/97 - Not too long ago, I shorted Rambus at $74. I thought the stock was way overvalued and I thought it had peaked. Within a few days the stock had soared to $84. I was near panic. What if it just kept going up and up. I could lose my shirt. So, I did the only logical thing I could ... I shorted it again

As those of you who have followed Rambus can guess, I made out pretty well in the end, but I sweated for a while. I'm doing the same thing with Amazon.com right now.

With all that anxiety, you may wonder why anyone would want to short? Well, for starters it is much easier to spot an overvalued company than an undervalued one. A company may appear to have great numbers but there is so much about the company's workings and its market that is hard to determine. Even with apparently great numbers, the company may be a bad deal. On the converse side, a company with weak numbers is almost certainly weak regardless of any other factors. And a company with weak numbers and a huge price is almost certainly overvalued.

Another benefit of shorting is as a hedge against your long positions. The stock you short is borrowed on your account margin. Anything you make above the margin interest rate is pure gravy to your overall return. Of course you can go long on margin too, but if the market tanks you could wind up in more debt than your shrunken margin will allow. If the market tanks while your short, your short position should buoy your returns while lowering your debt. Hopefully, you will have chosen well enough that your long positions rise more than your short position when the market is up, and drop less when the market is down.

There are a number of drawbacks to shorting. Since you are borrowing the stock you short, you could be called upon to replace it. If this happens, you will almost certainly be buying it back at a higher price than you sold it. Momentum investors love pulling this maneuver on shorts, helping them drive up prices further as the shorts are forced to cover. This happened quite recently with Yahoo. If you can hang on though, or short once the momentum has been lost, you should be in good shape.

I believe that to short successfully requires a willingness to stick to your guns when the market is against you. Individual Investor Magazine, in their latest issue, recommended three stocks to short. All appeared to be reasonably good choices. They also recommended that if the share prices rose 15%, you should cover your position. Bad call. If you had followed both parts of the magazine's advice, you would be down 15% on all three stocks. As with investing long, investing short sometimes requires patience.

Unlike investing long, you have to pay interest on your short position. Sometimes, you may just have to suck up a loss. By carefully examining a company's potential, reviewing its numbers, and checking its activity, you can minimize the chances of taking a loss. If you review some of the Hedgehog's short selections you can get a good idea of what we look for. In a later commentary, we'll spell out our criteria in more detail.

Happy hunting. There are certainly a lot of targets out there.

* For those of you who may not know, shorting stock means to borrow shares of a stock and sell them. You are betting that the share price will drop and you can repurchase the stocks at a lower price later. While you are short, you will pay an interest charge on the stocks you have borrowed.