CHAPTER 1

What Is Short Selling and How Can It Help Your Investing?

Key Concepts

* Reasons for short selling

* What is short selling?

* How to short

* The history of short selling

One of the key tenets for money managers is to focus on investing for the longterm. Over the years, the volatile swings will even out and your portfolio willsteadily increase. By taking a buy-and-hold strategy, you should be able togenerate 7 percent to 8 percent average returns—when including dividends.This is what history tends to show.

But is this really true? Can the markets be stagnant for ten or even twentyyears? Yes they can. Keep in mind that the time between 2000 to 2010 is oftenreferred to as the "Lost Decade," in which the Standard & Poor's 500 Index (S&P500) averaged a loss of 0.5 percent per year (of course, it would have been evenworse when adjusted for inflation). This did not even happen during the 1930swhen the United States suffered from the Great Depression.

It is true that statistics can be misleading, as the first half of 2000 was thepeak of the bull market. If the comparison was done from 2002, the numbers wouldlook better. Yet few would argue that 2000 to 2010 was not without extremevolatility. In all, there were two major declines in the markets, which included2000 to 2002 and 2007 to 2008. The decade also saw a variety of negative events.There was the real estate implosion, the accounting scandals of Enron andWorldCom, the terrorist strike on 9/11, the wars in Iraq and Afghanistan, andtwo recessions.

But can there be two lost decades? Looking back at U.S. history, there areexamples of this. For example, the 1929 crash led to a grueling bear market. TheDow Jones Industrial Average (DJIA) did not recover until 1954. Another case isthe period from 1964 to 1982, which also saw a devastating bear market. There isalso the terrible experience in Japan. Since the plunge in the Nikkei Index in1989, the markets are still 75 percent off from the peak.

Unfortunately, the U.S. economy is certainly facing major headwinds, which couldmake it difficult for the markets to post strong gains. Consider the views oftop money managers at Pimco like Tony Crescenzi, Mohamed El-Erian, and BillGross. They believe that the U.S. economy will have a muted growth path for thelong haul. One reason is that many of the jobs lost in the 2008–2009recession will no longer return. Industries like autos, housing, construction,retail, and finance have undergone tremendous structural changes. CorporateAmerica has also learned how to manage with fewer employees by usingproductivity-enhancing technologies and outsourcing to economies like China andIndia.

There has also been a massive destruction of wealth. Since peaking at $66trillion, the overall net worth of Americans has fallen by about $10 trillion.This will likely be a drag on consumer spending, especially as the Baby Boomersget older and start to retire. They will focus on more conservative investmentsbecause they do not want to run out of capital. Another major drag on theeconomy will be increased regulations. True, the near collapse of the financialsystem meant that it was inevitable that the federal government would get muchmore intrusive. Yet this will make it more difficult for companies to operate.Despite the regulations, it is likely that U.S. financial institutions will berestrained in extending credit. The fact is the consumers still have large debtloads. What's more, with lower growth prospects, there is not as much need forcredit.

The costs of the bailouts will also lead to higher taxes. At some point, thefederal government will need to take action to reduce the swelling budgetdeficit. And in light of the surge of retirements from the BabyBoomers—which will mean higher healthcare and Social Securitybenefits—it will be tough to find ways to cut costs.

In light of the potential challenges—and the complexities of globaleconomies—investors are likely to face more risk and volatility in thefuture. This is not to say investors need to avoid stocks or put money intoultra-safe securities like U.S. Treasuries. Instead, it means that it isimportant to look beyond just the purchase of securities—and consider howto make money when the values of investments fall. And of course, one effectiveway to do this is to use the investment technique of short selling.

MORE BAD STOCKS THAN GOOD ONES?

While any investor can have a hot streak, it typically does not last. Only ahandful of investors have been able to consistently beat the markets over aten-year period, such as Warren Buffett and Peter Lynch. Even with those whohave achieved this feat—like Bill Miller—there is often a periodwhen the returns eventually fall off.

The key to getting above-market returns is to find a few stellar performers.Picking stocks like Starbucks or Microsoft in their early years would have morethan offset the losers and average performers. Lynch famously called theseinvestments "ten baggers" (since they increased ten times or more).

Consider Li Lu, who is a candidate to manage Buffett's $100 billion portfolio.Since 1998, his hedge fund has posted annualized compound returns of 26.4percent. This compares to the Standard & Poor's return of 2.25 percent. However,a large part of the success came from an investment in BYD, which is afast-growing Chinese battery maker. Needless to say, it is exceedingly difficultto find these home runs. In fact, Li has found only one in his career. Actually,the fact is that—even for top investors—the chances are higher thata typical stock pick will fall in value. In other words, the odds tend to be infavor of short sellers.

This appears to be the case from a study by Blackstar Funds. The investment firmlooked at the performance of all U.S. stocks from 1983 to 2006. Given that thiswas during a large bull market, the typical return should have been strong,right? The conclusion is the opposite. About 39 percent of the stocks wereunprofitable and 18.5 percent lost at least 75 percent of their value. Only aquarter of the stocks accounted for all the value of the...