Most people’s first instinct when looking at a company is to weight the arguments for or against buying stocks, and if there appears to be too much downside risk they will simply move on to something else, but a successful short can be incredibly profitable. As Amit Kumar explains in his new book Short Stories from the Stock Market it can also be extremely risky.
Shorting stocks is for the financially experienced
“Shorting stocks is for the financially experienced and sophisticated investors with a strong stomach for losses. It can be potentially dangerous to your wealth,” he writes.
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People often think of shorting a stock as the opposite of buying it – betting against a company instead of betting on it – but that’s not really the case. To find a good long position, it’s enough to find a company that’s currently undervalued or has unappreciated long-term potential. Once you make the investment and you can sit back and wait for the rest of the market to catch up. But when you short a stock you’ve borrowed it from someone else, and the longer you hold on to it the more you have to pay for the privilege.
That’s why it’s not enough to find a company that’s overvalued, you need to identify specific corporate or industry weaknesses that will cause the stock price to fall relatively soon, and these tactical shorts are the main emphasis of Kumar’s book.
Short Stories: Sections
Short Stories from the Stock Market is broken up into three sections: a framework for thinking about short research, a section explaining how short analysts approach the market, and a nuts and bolts explanation of how short selling works. If you’ve never been directly involved in short selling you should probably start with the third section to clear up any misconceptions you might have and to refresh your memory about what the different options are.
But it’s the first section that is the real strength of the book. Developing a systematic approach to shorting is much harder than developing an approach to finding value stocks. As Tolstoy famously wrote, “Happy families are all alike; every unhappy family is unhappy in its own way.” At times the book feels like a long list of ideas more than a cohesive strategy, but that’s probably the nature of the subject. What’s more important is that the ideas are useful and backed up with case studies that explain them in concrete terms.
Momentum investors who just want to jump on to the latest rally might not have much interest in Kumar’s book, but value investors (even those who aren’t interested in shorts) can gain a lot of insight into what can go wrong from reading it. A lot of the weaknesses that tip Kumar off that a company may be ripe for shorting are the same signs that help distinguish a value stock from a value trap. His discussion of leverage, downside risks, and different ways to assess a company’s real potential are important for value investors who don’t want to get burned.
Ironically, value investors may even be a better target audience than people looking for short opportunities. “The discipline of short selling is not suited for an average individual investor,” he warns. But even if you never short a stock, learning how to spot big problems and avoid bad investments will still save you a lot of money over time.
Check it out Short Stories from the Stock Market