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Shortin' Ain't Easy

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February 09, 2011 – Comments (12) | RELATED TICKERS: CRM , NILE , OPEN

In a post the other day I mentioned The Big Picture's Barry Ritholtz's rules for shorting stocks that he has developed over many years of investing.  The first two rules were the ones that really stuck with me:

1. Shorting Momentum names is dangerous: Unless you are Superman, never step in front of a speeding locomotive

2. Valuation alone is insufficient reason to get short a stock — History teaches us that cheap stocks can get cheaper, dear stocks can get more expensive 

I have been burned numerous times shorting overvalued (at least in my opinion) momentum stocks here in CAPS.  For the most part, the stocks that have burned me the worst are legitimate companies, often with solid businesses, that just appear to be wildly overvalued.  Today I finally capitulated and closed a couple of this sort of trade of this type of short, including salesforce.com (CRM) and Blue Nile (NILE).  I have been burned in the past by shorting companies like Netflix and Amazon.com.  Fortunately all of these trades were only here in CAPS and not with real money.

Apparently, I'm not the only one who has run into trouble shorting momentum stocks with rich valuations.  Super investor Whitney Tilson recently capitulated and significantly reduced his short positions in a number of companies.

Whitney Tilson Reduces Short Exposure, Refocuses on Buying Cheap Stocks

Whitney Tilson and Glenn Tongue's hedge fund T2 Partners have had some rough sledding the past few months, mainly due to their large short exposure. Over the last five months, they are down 4.3% net while the S&P 500 has rallied 23.5%. As such, they've re-examined their portfolio construction and have concluded to reduce short exposure and get back to basics: buying cheap stocks.

Rationale for Reducing Short Exposure

Tilson cites the fund's maintenance of a large short book after the crisis as the primary mistake. Additionally he writes,

"Over time we've been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme. Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them entirely unless we have a high degree of conviction about a specific, near-term catalyst."

The immediate thing that comes to mind is their well-documented 
short position in Netflix (NFLX). This short is obviously classified as a 'valuation short' but T2 notes that they are still digesting the company's recent earnings as well as other channel checks and it is unclear as to whether or not they've adjusted their position in anyway.

Interesting stuff.  I still have 19 short positions open here in CAPS.  Using the logic that shorting pricy momentum stocks is dangerous, I probably should close my OpenTable short.  I haven't yet because I think that its valuation is absurd.  I also have not yet close my shorts of Tesla or RealD.  The best type of shorts are outright frauds or situations / companies that are fundamentally flawed.  I will continue to short stocks like these, but I plan on staying away from richly valued companies with solid businesses from now on.

Deej 

12 Comments – Post Your Own

#1) On February 09, 2011 at 7:50 PM, TMFDeej (99.41) wrote:

PS. I just realized that my links won't work because I wrote this post in Safari.  Here's a link to the article that I mentioned

Whitney Tilson Reduces Short Exposure, Refocuses on Buying Cheap Stocks

Read more: http://www.marketfolly.com/2011/02/whitney-tilson-reduces-short-exposure.html#ixzz1DVqX2qav

Deej 

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#2) On February 09, 2011 at 8:38 PM, ikkyu2 (99.32) wrote:

I sometimes wonder if there is anything you need to know about short-term trading that isn't in "Reminiscences of a Stock Operator."  Livermore summed it up very succintly: Never fight the tape.

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#3) On February 09, 2011 at 8:38 PM, GrowthnValue (< 20) wrote:

I don't understand NILE's price.  Something like NFLX is a great and growing company which may be overvalued.  If they can become the premier worldwide streaming movie company, they may be worth their price or more (of course that is a big if).  I can also see some competitive advantages.  OPEN seems wildly overvalued to me, but again it is a big grower.  I also think it has a nice moat (a critical mass of restaurants and users).  On the other hand, NILE is a fine business, but no big growth.  I don't see what could happen to make them worth their current price.

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#4) On February 09, 2011 at 8:57 PM, nuf2bdangrus (< 20) wrote:

I usually use puts or put spreads, and shorting cost me a bundle in real money.  So much for hedging. 

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#5) On February 09, 2011 at 11:04 PM, goldminingXpert (29.47) wrote:

I would much rather short stocks that are already weak and getting weaker rather than momo names. Not that I've traded YONG (and I'm not recommending shorting it after speaking with their CFO today), but I think stocks like it are more attractive because they are closer to their 52-week low than high, there is substantial skepticism about their business, and there's very little chance of getting squeezed in a short covering rampage (the stock has been listlessly trading in a channel for ages). When the stock finally breaks down, as it did on Monday, it does so in an orderly fashion and fails to generate any kind of meaningful bounce thus far. Why take on a train when there are slower-moving vehicles?

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#6) On February 10, 2011 at 12:56 AM, checklist34 (99.71) wrote:

Deej, good post and something I've pondered a bit this year, as I hope to short my first stock sometime in 2011 and I don't want to get it wrong. 

The challenge that I have with it is ... I just don't know if my brain thinks the right way to be a good short seller.  I like looking at companies that are beaten down and far off recent highs and deciding whether they will live or die.  I have a great real life track record of doing that.

when I see guys waiting to buy until something goes up another 2 bucks or 10%, I get perplexed and quickly go read another blog.  But thats how A WHOLE LOT of people operate, and that creates the ability for the insane valuations that hot momo stocks get.

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#7) On February 10, 2011 at 12:56 AM, checklist34 (99.71) wrote:

Deej, good post and something I've pondered a bit this year, as I hope to short my first stock sometime in 2011 and I don't want to get it wrong. 

The challenge that I have with it is ... I just don't know if my brain thinks the right way to be a good short seller.  I like looking at companies that are beaten down and far off recent highs and deciding whether they will live or die.  I have a great real life track record of doing that.

when I see guys waiting to buy until something goes up another 2 bucks or 10%, I get perplexed and quickly go read another blog.  But thats how A WHOLE LOT of people operate, and that creates the ability for the insane valuations that hot momo stocks get.

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#8) On February 10, 2011 at 12:58 AM, checklist34 (99.71) wrote:

GMX, the risk with that is something near its lows, shares already performing badly, probably certainly has a viable short thesis, there is probably a real risk or problem or whatever... 

But what happens if the problem is resolved?  ALD got bought out for many times its value when it was near its last 52 week low.  ACAS survived.  GGP lived to thrive again.  TCK didn't go broke, ASH lived, XL/GNW/HIG all lived.  On and on.  

I suppose in todays market nothing is beaten down even close to where those things were when I bought them...  so perhaps my point is null.

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#9) On February 10, 2011 at 1:49 PM, SultanOfSwing (97.82) wrote:

As such, they've re-examined their portfolio construction and have concluded to reduce short exposure and get back to basics: buying cheap stocks.

It seems odd to me that T2 Partners would choose to employ that strategy now.  I think the risk-reward is with shorting more now, then back when they were less successful.  Time will tell whether they were right or whether they got spanked in both directions.

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#10) On February 10, 2011 at 4:00 PM, tgauchat (81.48) wrote:

Momentum stocks ALWAYS eventually lose their momentum. Scale in ... keep lots of reserves. Be strong.

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#11) On February 10, 2011 at 5:19 PM, davejh23 (< 20) wrote:

"Whitney Tilson and Glenn Tongue's hedge fund T2 Partners have had some rough sledding the past few months, mainly due to their large short exposure. Over the last five months, they are down 4.3% net while the S&P 500 has rallied 23.5%. As such, they've re-examined their portfolio construction and have concluded to reduce short exposure and get back to basics: buying cheap stocks."

I've seen lots of stories like this recently.  This worries me more than insider selling...bears are giving up. 

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#12) On February 10, 2011 at 5:38 PM, portefeuille (99.50) wrote:

Why We Covered Our Netflix Short (pdf)

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