Short Selling Tips
By Timothy Lutts, Cabot Chief Investment Strategist and Editor of Cabot Stock of the Month Report
From Cabot Wealth Advisory 6/23/08 Sign up for free Cabot Wealth Advisory e-newsletter
Short-selling is a way to bet that a certain stock will be lower in the future. Basically you sell a stock that you don't own in the expectation that it will decline and you can buy it (cover) at a lower price in the future. It's just like buying low and selling high, except that you do it in reverse order.
At Cabot, we don't have any official recommendations for short-selling, in part because interest in the topic is far smaller than it is for traditional long investing, and in part because it's more difficult.
One, fear is a more intense emotion than greed, and thus big drops tend to happen quickly. That means your timing when shorting must be very precise, which is difficult for even the best professionals.
Two, the mathematics of the proposition are less attractive. When you go long, the worst you can do is lose all your money; the best you can do is unlimited gains, 10-fold, 20-fold and more. But when you sell short, the best you can do is double your money (less commissions.) The worst you can do is unlimited; you can lose 10 or 20 times your money!
Another factor, immeasurable but important, is psychological. We prefer to hone our skills in going long, discovering great growth companies and buying their stocks at the right time. To contaminate that thinking by looking for the opposite would hurt our efforts in the main, most profitable avenue of investing, and we think it's not worth it.
However, if you're determined to sell short, I do have a little advice.
– Target companies with declining sales and earnings.
– Target stocks of large companies that have declining public and institutional perception. That creates a large supply of selling pressure. (Can you think of any automobile manufacturers or airline companies that qualify?)
– Only sell short when the market's intermediate-term trend is down.
– Never (never!) try to pick the top; only sell short stocks that are in confirmed downtrends.
– Pick your sell point carefully, trying to sell after the end of a normal rally upward, preferably to the declining 50-day moving average.
– Don't get greedy. When you have a decent profit after an extended period of downside action, take it.
– And finally, cut all losses short. If the stock continues to rally after you short, cut your loss at 10% to 15%.
The most dangerous way to sell short is to pick a hot little stock that's "way overvalued" and bet that it will come down.
Such a case in recent weeks has been American Superconductor (AMSC), a company that for years focused on the hard-to-develop market for low-temperature transmission of high-voltage power but recently found new life by entering the market for wind energy.
Back on May 1, American Superconductor was featured in Cabot Green Investor, where editor Brendan Coffey wrote the following:
"Originally founded to develop highly conductive wiring for power systems, American Superconductor has used that expertise to expand into a few promising areas, the most significant of which is wind turbines. While American Superconductor already had some exposure to the business, it transformed itself into a wind energy powerhouse with the acquisition of Austrian firm Windtec in early 2007...
The Windtec division designs wind turbines that other companies incorporate into the wind towers they build on behalf of wind farm customers. The arrangement is a lot like razors-you buy the razor itself, but then you have to buy the blades repeatedly in order to be able to use it. As Gillette found out many years ago, there's money to be made in selling the razor, but much better profits to be found in the blades.
American Superconductor has other major clients with favorable arrangements, including Germany's Fuhrlander and Canada's AAER. It also just announced its first deal in India, with Ghodawat Industries, which will market turbines based on Windtec designs to India, the Middle East and Africa.
Overall, the company is focusing growth in two regions-North America and China. In the U.S., utilities are expected to double their wind power spending this year, driven by a federal production tax credit of 2 cents per kilowatt-hour. China is expected to ramp up even faster; by 2020, China wants to increase its wind energy capacity more than 13-fold to 80 gigawatts."
Back then, with the stock trading a 26, Brendan rated AMSC a buy, writing, "Resistance is seen at $28.50 and $32, with good support seen around $24 and then around the $20 mark."
Since then, the stock has been on fire. Friday it closed at 43, after pulling back from a high of 45 two weeks before.
And here's where the short-selling story comes in. (I hesitate to spend much time on this, because, as I said, it detracts from our main focus, but here it is.) There's a firm named Citron, run by a man named Lemon (get it?), that specializes in short-selling, and in publicizing (criticizing) the firms it is shorting in order to help drive their prices down. American Superconductor is one of Citron's targets.
Apparently, Lemon questions whether the orders American Superconductor professes to have or expects to have will truly bear fruit.
Now, some people, reading his critique of the company, will sell their shares, or even sell short. But others, believing that the company is truly in the early stages of a major growth wave, will buy. Me? I don't believe or disbelieve anyone; I believe the chart. Remember, the goal is not to be right; the goal is to make money. Think about that. Tattoo it
on your chest if you want. (I'm not into tattoos.)
So what does the chart say? For the past five months, AMSC's chart, in climbing from 16 to 45, has rewarded investors who were long on the stock, and it has punished short-sellers...despite the broad market being unsupportive. The chart, which typically reflects the opinions of all investors with an interest in the stock, appears to be telling us the future is bright for this company.
Volatility in the stock, however, is likely to be substantial for some time to come. If you're inclined to buy, I recommend that you choose your entry point carefully. Today, the stock is consolidating under resistance at 45, and there's support at 37, though a breakdown below 40 might kill the short-term momentum.
Finally, I want to close with this one big thought. There's a lot of talk about the price of oil today ... perhaps too much. Everyone wants to know when the price will decline...or whether it will stay up here. I ask a different question. I ask, "Given the new reality that limited supplies of energy and growing demand make high energy prices likely in the years ahead, what are the investing opportunities in alternatives?" I think AMSC is one of them.
Click here for information on Tim's Cabot Stock of the Month.
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