What are some of the best techniques for selecting stocks to short?

What are some of the best techniques for selecting stocks to short? by Laurent Bernut

Answer by Laurent Bernut:

Two parts: let’s start with stuff that does not work and end with stuff that works.

Part 1: stuff that does not work

High short interest:

Short interest and/or borrow utilisation is a function of supply and demand. Supply of stock available for borrow and demand from short sellers. So, when short interest rises, it means two things:

  1. Supply is drying up: institutional long holders liquidate their positions. Remember that whatever information that has led You to conclude something is a short is also available to long holders, who probably conclude it is not worth holding anymore
  2. Demand from short sellers is increasing: unlike going Long, going short is a finite universe. There is a limit to the amount of shares available for borrow. So, You will end up competing with short sellers and stable shareholders, those who never sell

Analysts downgrades:

Analysts are chronically late to the party. It is difficult for them to downgrade their ratings, especially when the whole investment banking food-chain depends on them rating stocks as Buy. Example: Enron was rated Buy days before its collapse.

Bottom line, You don’t need analysts in Bull markets and You don’t want them in bear markets

Fundamental newsflow deterioration:

Many market participants wait for deterioration of fundamentals before putting on a short. Well, if You believe that markets are discounting mechanisms of future events, waiting for the confirmation of those events is by definition late. This is called confirmation bias.

On the short side, it often comes from painful experiences. Market participants often start with anticipation shorts: unsustainable valuations, momentum etc. They get carried out a few times. So, their next move is confirmation short: wait for fundamentals to really suck before putting on a trade. They then compete with other fundamental short sellers.

Vigilante short selling

Tourists short sellers often short stuff that does not make sense anymore. They go after crazy valuation, parabolic momentum etc. They may be right in theory, but they are invariably wrong in practice. One sane person versus an irrational mob is still an unfair fight.

Personally, i have no sympathy for those market participants. They put other people’s money in harm’s way. Their egos breach their fiduciary duty to their clients. Luckily, they don’t hang around for too long

Part II: stuff that works

Momentum:

Between the time a stock should go down because valuations & momentum are unsustainable and the time when a stock should go down because fundamentals are horrible, there is a long period of time when price actually DOES go down. Reality is the time between the “should”

Look for downward relative momentum first, then weave whatever rationale You want.

“Buy” for the long term investor

My favorite of all times is a blind spot of analysts. Within their coverage, there is always a buy rated stock that performs poorly. They call it “Buy for the long-term investor”, meaning short term it will go down and You have to be patient.

So, as a good acid test, thank the analysts for the info and ask them if they would like to be paid long-term commissions for those long-term ideas. If they grimace, then Short

Relative Shorts

Before Valeant (VRX), Wells Fargo, Deutsche Bank, Lehman Brothers, Enron drilled a hole in the earth’s crust in absolute, they underperformed their benchmark for some time.

Relative momentum (Absolute Price / Benchmark price) is by far the surest way to find good shorts. a good Long/Short portfolio is composed of Long book of outperformers and a Short book of underperformers.

Putting everything in relative terms will immediately increase the number of short ideas.

What are some of the best techniques for selecting stocks to short?

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