The Basics and Risks of Short Selling


A short sale is the exact opposite of the purchase of a stock, in that an investor makes money
when the stock goes down in price and loses money if it goes up.  In
a short sale an investor borrows shares of a company and sells them,
collecting the proceeds from the sale.  At a later date he purchases
shares on the open market, thereby replacing the shares that were
borrowed and closing the transaction.  The shares are sold first,
then bought later.  Like a normal stock purchase, money is made when
they sell for more than the purchase price.

Some of the terminology of short sales:

Cover: To buy back shares that were sold short, closing the transaction.

Buy Long: To buy stocks or other securities in the normal fashion, such that increases
in price result in profits.

Naked Short: A trade in which the shares are not borrowed before being sold short.
This is an illegal transaction because it can allow for a great deal
of shares to be sold short that don’t exist, upsetting the balance
between buyers and sellers, causing price manipulation.

Short and Ultrashort ETF: Funds designed to go down when the underlying index goes
up, with equal percentages on a day-to-day basis.  These are
typically not recommended (see post DIG and DUG).

Despite looking like a standard stock trade, but done in reverse, there are some special
nuances that must be understood about short sales .  These are:

Tax implications:
Short sales are always considered short-term trades, no matter how
long they are held open, probably because short selling is considered
somehow sinister or evil.  (Disclaimer: Note that as with all tax
advice, this should be checked with a CPA since I am not one and
could be wrong).

Time Frame:  Short sales
are inherently short to mid-term investments.  Because the tendency
of the stock market is to increase in price, time works against the
short sale.  Going short a stock and then forgetting about it is not
a good strategy.  For this reason, selling short is more speculation
than investment.

Risk:  It is often said that short selling is more risky than buying long because your
loss is limited when buying long (the stock can only go to zero),
while a stock can go up forever.  While this is technically true, the
risk is manageable because stocks don’t go up infinite amounts as
long as the investor is very disciplined and has a firm price target
above which she will cover and close the transaction, no matter what.
Note that if the company is bought out or other big news occurs, the
stock may shoot right through the target, but even then stocks don’t
just go from $10 to $500 in a day.  Still, because time works against
the short sale to some extent, there is more risk in selling short
than going long.

Effect of bad positions:  If one buys long and a stock goes down, while a loss
is being taken, the position becomes a smaller and smaller percentage
of the portfolio as the stock declines.  With short selling, if the
stock goes up, the position becomes larger and larger.  If the amount
owed for the short sale goes above the amount of cash in the account,
the investor will need to add more cash or start paying margin
interest to the brokerage (which is where firms actually make their
money).  If the stock rises far enough, a margin call can be executed
that will force the investor to cover the position and lose
substantial amounts.  Also, if a loss is taken on a short sale, money
must be found to pay for brokerage commissions in addition to the
loss, where with selling at a loss on a long position at least the
money gained from the trade will at least cover the brokerage costs.

Margin Interest:
While a stock is sold short, it is a liability against the account.
If there is not as much cash in the account as the value of the short
sale, the investor will need to pay margin interest on the
difference.  Also, this cash will not receive interest (it is held
against the short sale).

As can be seen, there are many specific risks and disadvantages with short sales; therefore,
they should be seen as a speculation, not an investment.   Still,
there are sometimes when selling short makes sense.

The time when it may be worth selling short is when the market is so unbelievably
over-valued, or the likelihood of the market falling is so great
(like in the summer of 2008), that stocks in general, or at least in
a certain sector, are much more likely to fall than to rise.  In
general, even in this case short selling is done only as a hedge for
long positions – trying to offset losses in long positions by going
short on other stocks.

For example, in the summer of 2008 the housing bubble was threatening to burst.  I owned
a lot of retailer stocks that I knew would be hurt if consumers were
no longer able to roll their credit card balances into their home
loans, but I did not want to sell the stocks outright.  I decided
therefore that shorting some of the lenders would be a good hedge.

Since the lenders had been doing very well and the price of their shares had risen a lot
over the past few years, I reasoned that their stocks were not likely
to go much higher unless I was very wrong about their earnings
prospects.  I also felt that they would get hit hard when the ARMs
reset and people stopped being able to make their payments.  At
least, I thought, that the number of new loans they would be
making-which is where they made most of their money-would decrease,
causing their stock price to fall since earnings would no longer be
growing at their previous torrid pace.  I therefore took up short
positions in several lenders.

I also saw that oil prices were very high, and that the price of oil stocks was probably
as high as it would get.  I thought that if the economy slowed down,
demand for gasoline would fall.  Because the shares were already at
high prices, I reasoned that they were unlikely to go a great deal
higher.

Even though I was eventually right and did very well in 2009 while most were taking
large losses, it was not uneventful.  Shortly after I took up a short
position in Golden West Financial, the stock was bought out, jumping
from about $20 to the mid-thirties in a day.  Eventually Golden West
Financial gave great heart burn to the company that acquired them.  I
was right about the future of Golden West’s business, but that was
of little solace to me because I had already lost quite a bit on the
trade when the company was acquired (I had a similar experience with
Snapple).

So to sum up, short selling can be profitable, but the interim movements of the stock you
are shorting can cause losses, even if you are eventually right about
the company.  Also, just because a stock is very expensive doesn’t
mean it can’t go higher for a while or that another company might
not buy it out for even more money.  I therefore only sell short when
I believe there are systemic risks in the market and I wish to hedge
against a fall rather than selling outright.  I also only short
stocks that I believe have gone up so much that they have more room
on the downside than the upside.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Should You Buy Dividend Paying Stocks?


Utilities, which tend to pay high dividends and have a regulated monopoly, meaning that they have predictable earnings and rarely lose money, were once thought of as “widow and orphan” stocks.  These were stocks for those who needed steady income and could not take a substantial risk.  People would give up the potential gains from growth stocks and smaller companies that could provide large capital gains in exchange for the relative safety of a steady dividend.

Companies that pay large dividends tend to be large companies late in their life cycle.  They have already grown as big as they will and now have a steady business that provides a good cash flow.  Because they are not growing rapidly, they are able to distribute money to investors.  They are not acquiring other companies and opening new locations.  Note that even if they continue to grow (Walmart and Microsoft are still expanding, for example), they are so big that they simply cannot grow at the rate of smaller companies.  For example, how much more oil would Exxon need to produce to double their earnings if oil prices remained fixed?

In fact, the pricing of all stocks assumes that some day they will either start paying a dividend or be bought out by another company that will.  If the company were to keep reinvesting all of their earnings in acquisitions and growth, while the company would be getting bigger and earnings would be increasing, the share holders would never receive anything for their investment.  Eventually the company is expected to reach its elder years and start to pay out a good protion of their earnings in a dividend.  When buying a young stock, the price paid is actually a factor of how large the stock is expected to be, and thereby how much cash it will have for dividends, combined with how likely it is to obtain that size and how long it will take to get there.

So stocks that pay large dividends generally cannot be expected to grow significantly; however, they add stability to a portfolio and (nearly) guarantee a return even when the market is flat.  Those who bought pure growth stocks during the 2000’s may have seen no return at all (at least of  they bought enough to mimic the behavior of the whole market, which has been relatively flat).  If they bought stocks with a 4% dividend, however, they would have at least gotten a return of 4%.

Another advantage of dividend paying stocks is that they tend to be more stable in price.  This is because as long as they are able to keep paying the dividend the yield of the stock will put an effective floor on the price.  If a stock is paying $1.00 per share per year, at $10.00 per share the stock will be paying a yield of 10%.  If it drops to $5 per share but the dividend remains unchanged, it will be yielding 20%.  At some point the yield will become so big that investors will come in and buy the stock  simply for the dividend.

One must be careful, however, when buying stocks with outsized yields.  If the business is suffering along with the share price, the company may not be able to continue paying the dividend and may need to cut it.  When that happens, if people are buying the stock simply for the dividend, the stock may fall in price dramatically.  When looking at stocks, make sure the earnings are substantially larger than the dividends (maybe 2 times as much) and that the company has plenty of cash flow.  Also, see if their peer companies are paying comparable dividends or have cut their dividends recently if they are not.

Finally, dividend paying stocks aren’t for everyone.  When you are just starting out and have little money to invest, growth should be the primary driver.  Investments should be made in stocks that are likely to grow rapidly and produce large returns.  As one starts to build up a substantial net worth, however, and the focus turn from growth to stability and income, the inclusion of some high dividend paying stocks is a necessity.

Think of it this way.  A portion of your portfolio should be for increasing wealth.  This is the portion that is filled with growth stocks – companies that are small and growing and have great prospects for years to come.  The other portion of your portfolio should be for capital preservation.  This includes high yield stocks, bonds, and mutual funds that invest in large portions of the market.  These are established companies and the preferred stocks of companies.  These stocks are not expected to provide a significant portion of their return in capital gains (although the price will generally tend to increase with inflation), but they will provide stability and help protect your net worth during downturns.

As time passes and your net worth grows, and as you get closer to needing the money, the growth portion as a percentage of your portfolio will decrease and the income/stability portion will increase.  As you really start to need the money, some stock should be sold and converted to cash to provide even more of a cushion against downturns.  I always hate to hear about people putting off retirement because of a drop in the market.  With proper asset allocation, you won’t be one of them.  This includes allocating a portion of your portfolio to high yielding stocks when it makes sense.  When they drop, you can sit back and collect the dividends while you wait for them to recover.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Price of Houses


With the bursting of the real estate bubble, everyone is asking when home prices will stabilize.  Even more, they are asking when the prices will return to those seen in 2007 before the bubble burst.  This expectation that the prices of houses should return to where they were during the boom is a common mistake that is seen in stock investors as well.

To understand the mistake, you first need to understand the psychology of bubbles.  Most bubbles involve substantial amounts of credit which allow people to bid up the prices of things beyond where they can be supported if everyone were paying cash.  One of the reasons the stock market crash was so great in the 1930’s was that a lot of the stock had been bought on margin.  Likewise, a lot of the homes bought in the 2000’s were purchased with no money down and very low payments (at least initially).  This meant that the normal price controls – in that if you raise the price high enough there is no one who has the money to buy it – did not work because people were able to purchase homes that were far out of their price range by using credit.  This lead to an increase in home prices, which caused more people to get these loans and bid the prices higher.  Like all bubbles, prices got to a totally unsustainable level.

The home bubble was even a bit more insidious in that people started taking out home equity loans on the inflated price of their homes, which allowed them to spend money they did not have on all kinds of stuff.  This produced a market for vacations, products, and services that would not have been there if people had been paying cash.  The size of the true economy was distorted.  All kinds of jobs existed to meet demand that was a fantasy.

When homes stopped going up in value, all of the borrowing stopped.  This meant that all of the people who were providing all of those goods and services to people who did not make enough money to afford those services lost their jobs.  While it appeared that there was enough business for 20 coffee houses and 30 movie theaters and 15 car dealers, there was really only enough business for about half the number of each.

This is the nature of bubbles.  The demand is not real demand – it is demand borrowed from the future earnings of people.  This creates an artificial economy.  The apparent value of things, like the homes, the stores, and the companies providing all of these services is not its true value.  It is a castle built in the clouds, ready to fall to earth as soon as the cloud vaporizes.

So be it houses or stocks, just because something once sold for some price does not mean that it was ever worth that price, or that it will ever sell for that price again.  Particularly if it was during a bubble that the prices were set.  The bad news is therefore that even after the economy begins to recover, it does not mean that the level of jobs will return to where it was, or the price of homes will return.  The good news is that it may not take as good paying a job to afford those homes.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.com or leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.