Why I'm a big fan of short-selling

published 6 January 2012

Finding a great stock is tough. It's not enough that the business trades well. For your stock to go up, you'll need market sentiment on your side too.

In many ways finding a terrible stock is easier. When a company's in dire straits, the business fundamentals have a habit of deteriorating further. Good staff leave, banks, suppliers and customers turn their backs on you and the business slides into depression. As well as the fundamentals dragging the stock price down, poor sentiment screws the price into the floor.

Though it's often vilified, arguably there is a lot to be said for short-selling stocks. If it's easier to find a stock to short than one to long, then why not?

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And last year my short recommendations did very nicely. We had great success with HMV and Ocado, as well as shorting the banking sector as a whole.

Let's take a closer look at this maligned strategy. Whatever you may think of short selling stocks, there's no doubt that it throws up opportunities for the brave.

No one likes us, we don't care!

Last week I was talking to an old friend who told me about his successes with shorting stocks last year. Usually when he talks to people about it he ends up humming the old Millwall football supporters' chant: "No one likes us, we don't care!" in his head. His investment style isn't very well received but then again, he doesn't care.

And I know many readers hate the idea of shorting stocks. It can be very dangerous as you're potentially exposed to unlimited losses if the stock goes the wrong way (ie up). But the vilification dealt out by the 'long only' community is more to do with the idea that short-selling can illegitimately bring down a healthy company.

It's certainly a view shared by many European ministers. During the initial crunch (and more recently) they outlawed the short-sale of financial stocks. And it's true that speculative attacks on share prices can destroy faith and bring about solvency issues.

And I agree, it's kind of galling to know that your own shares held in a nominee account with your stockbroker can be 'lent' to short-sellers. And these guys want to bring down your stock!

But I've got to say, on the whole, I don't care.

Investment is a long-term game. If the short-sellers are wrong, they're going to pay for their mistake. And in the meantime it opens up opportunities for the long term investor.

I've lost count of the number of times when 'short attacks' gave me the opportunity to buy in cheaply.

Of course you can never really know whether a price dip is the result of shorting activity, but there are clues.

How short traders can help you find great stocks

Companies such as Data Explorers release data about the most loaned out stocks in the market. For instance,they tell us that short interest on retail stocks is currently 3.4% -that's more than double the rate for the FTSE as a whole. M&S is the most shorted with around 5% of its stock out on loan. Most stock exchanges track the short interest in each stock and issue reports at month's end.

Following discussions on popular bulletin boards can also help reveal shorting trends. Popular threads can have epic and bloody battles between the longs and shorts. One stock that's seen such a battle recently is Supergroup (SGP). I'm convinced that the shorts have taken a disliking to the business for all the wrong reasons. At one point the shares even traded below their £5 IPO price.

And sure, as a holder the knock-down price bothers me. I'll provide an update on SGP after the Christmas trading results are published on 11 January. It's a classic example of a business that's trading incredibly well, but where market sentiment is against it.

There could be a great opportunity in gold miners

Another area of the market that seems to have suffered at the hands of the short sellers is gold mining. But I expect some of the big producers to start raising dividends and those are dividends that will have to be paid out by any short sellers.

It's worth remembering that if you are long a stock, you get dividends and if you're short then you have to pay them. At some point short sellers will get stung for higher dividends and they'll want to cover their shorts. That could be a great driver for the shares of some gold miners.

To sum up, there's undoubtedly a dark side to short selling. But one shouldn't ignore the opportunities. Not only can you use shorts to provide a much needed hedge against market downswings, but you may often be presented with opportunities to take the other side of wrongly shorted stocks.

I suspect 2012 will provide plenty of prospects on both sides of the fence. And there are a few trades I'm sizing up that you might be interested in I'll let you know all about it soon.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.