Three lessons you must learn to survive a short-selling attack

Who are the most hated individuals in the financial world?

Politicians? Investment bankers? Estate agents? Overpaid FTSE 100 chief executives?

I reckon they'd all rank highly on lots of people's lists. But I also reckon there's one group more vilified than any other short sellers.

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Short sellers make money by betting on a company's share price falling, rather than rising. Because of this, they're condemned as vultures' and worse profiting from misery. They're among the few groups of investors whose activities were banned outright during the financial crisis.

But a brilliant story from last week shows exactly why we need them and also shows just how much private investors can learn about investing by copying their methods

A stunning victory for short-sellers

Last Tuesday, infamous US short-seller Gotham City Research published a damning report on a high-flying Spanish stock.

It alleged that 90% of revenues at public wifi provider Let's Gowex did not exist. Gotham's share price target? A big fat zero.

Gowex's share price dived by about 60% in a couple of days, before the shares were suspended.

The Spanish regulator (Mercado Alternativo Bursatil) was appalled. It asked the American and British financial watchdogs for information on Gotham. As FT Alphaville notes, it said "it wanted to determine if there have been illegal operations' on the part of Gotham". It also said it would investigate share trading patterns in Gowex in the few days before the report was published.

What happened next? Gowex went bust.

The company declared bankruptcy yesterday, as its chief executive and founder, Jenaro Garcia Martin, admitted that he had been falsifying the company's accounts for at least four years.

Hitting a price target of zero within just five days? That's a pretty impressive performance. And if Gotham was acting on its own views and surely it was the company must have made a lot of money.

Short-sellers aren't the only biased investors in the market

British investors might know Gotham better from a report it put out in April on Aim-listed insurance claims processor Quindell. The report wasn't as scathing as that on Gowex, but it did question the way the company reported its earnings. Shares in Quindell took a battering as a result.

Now, to be very clear, I'm not taking sides here. I hold no position in Quindell (either short or long) and I haven't researched the stock myself. And clearly, Gotham has (or had) a vested interest here. Quindell itself addressed the points raised by Gotham in detail, and said it had launched legal proceedings against the short seller.

So you can see why investors are suspicious of short-sellers. These people aren't neutral. They can stick out a damning report, which may or may not be correct, then watch the shares tank, and be in and out before they recover.

However, you can say the same thing for almost everyone that covers a stock. You very rarely see mainstream analysts put out a sell' recommendation, for example. That's partly because regardless of new compliance laws their bank wants to win business from companies, and you don't get that by issuing sell' reports on their stock.

But it's also because the market as a whole is long' the majority of investors are betting on stocks going up all the time. And the whole system is geared to making everything rise from central bankers to politicians to pension funds, everyone wants a rising market.

So being the bearer of bad tidings is not a popular position to be in.

Three lessons you can learn from short-sellers

And as far as I'm concerned, this is one very good reason why investors should train themselves to think like short-sellers even if they're not going to go short themselves.

What does it take to be a successful short-seller? Firstly, you need to be contrarian. You need to go against the wider market. You need to be willing to bet on stocks falling, not rising.

One thing that all of Gotham's targets have had in common is that they've been riding high on investor sentiment. So regardless of the truth of Gotham's allegations, they've all been priced so as to be vulnerable to any small setback.

Secondly, you have to have conviction. Short-selling is highly risky. If you short-sell a stock, and it rises instead of falling, then your losses are theoretically unlimited. Also, this is not a buy and hold' occupation. The stock needs to go your way quite quickly, because holding a short position costs money. So unlike long' investors, if you get it wrong, you can't just sit on your position and hope it comes good eventually.

So you really have to believe in your case if you are going to take a short position. And that leads us to the third point: you have to do your research carefully.

Gotham's views on the companies it has targeted may or may not be fair. But the short-seller has chosen targets in hard-to-understand industries, whose accounts are complex enough, to have investors second-guessing themselves.

If long' investors in these companies were genuinely confident that they understood what they'd been investing in, then the short attacks would have no traction. It's only because investors worry that they might have a point, that the bear raids' actually work.

So that's three lessons for private investors to learn from short sellers.

Be contrarian don't invest in companies that are priced for perfection, because anything less will leave them vulnerable to a crash.

Have conviction only invest in stocks and assets where you can build a good case that your view is correct and the market's is wrong.

And finally, do your research. As Warren Buffett always points out, only invest in companies that you can understand. That way, you won't get caught panicking if someone questions your view and you don't have any answers for them.

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