Enter a symbol:
For Toronto: TSX:TD
 



 
You are here :  Home > Articles > Page 3 > Profitability Of Short Selling
 PROFITABILITY OF SHORT SELLING
 

   This is a translation of the former paper published by André Gosselin on the OrientationFinance.com web site on June 28 2005 ( Read the original paper in French here).

 

   * Paper written by André Gosselin published on the lesaffaires.com web site.

   Before selling a stock short, said Peter Lynch, it is necessary for you to have more than the conviction that the company is at the edge of the disaster. You need the patience, the courage and the money necessary to hold on if ever the stock does not fall, or worse, if it goes up.

   "The stocks which price is supposed to drop but does not drop, he writes with his famous sense of humour, remind me of these cartoon characters who do not fall from cliffs but continue to run in the airs. As long as they do not become aware of their difficult situation, they remain indefinitely up there".

   There are then many investors, those days, who lose significant money trying to sell stocks short. Let us hope that they are not the same ones as those lost so much with the blowing of the tech bubble, and who now try to regain their funds by the mean of short selling.

   Among the stocks having the strongest volumes of short selling (in absolute figures), we can find Microsoft, INTEL, Cisco, Amazon.com, Oracle, Dell, Amgen and Yahoo. One cannot say that those are companies on the edge of the bankruptcy. Several experts in management would say that they are excellent companies, among best managed and the most innovative in the world. Moreover, Microsoft, INTEL and Cisco are also among the 20 stocks the most present in the portfolio of the American households.

   It is probably for this last reason, among others, that some daring investors decide to sell them short. As remarkable as they are, they generally believe that the stocks of these companies are traded at a too high price.

   Thus, it seems that a short selling strategy very popular among our southern neighbours aims directly the most popular companies. It is not possible to be more against the trend. These investors make simply the bet that the most popular stocks are always too expensive, and that sooner or later they will adjust to a more normal price. A bet that Peter Lynch would certainly find too risky.

   Of course, one finds in the list of the 20 favourite candidates for short selling, some companies which by are not necessarily recognized for their excellence. They have a worrying debt level, little or not of profits, and their business model is very fragile and dubious. I think in particular to Charter Communications, Sirius Satellites, XM Satellite Radio operator, Level3 Communications, Nextel Communications, Comcast, InterActive Corp. and Juniper Networks.

   No more than ten studies can be found about the short selling returns. Most of them show that this investment strategy, such as it is practised on the American markets, is a profitable activity. Those who are devoted to the short selling, observe the researchers, are more qualified and informed investors that the average, and the return of their portfolio reflect that.

   The two most interesting and exhaustive researches, to my knowledge, are related to the AMEX and NYSE markets for the 1976-1993 period (Dechow and Al), and the Nasdaq market over the 1988-1994 period (Desai and Al). In both cases, the researchers showed that the stocks the most sold short (by comparing the proportion of their shares sold short with their volumes of outstanding shares) generate indeed negative returns and thus, seemingly, profits for the short sellers. And let us not forget that they had realized this accomplishment in a strongly bullish market.

   One imagines very well that their performance was even better with the bearish markets in 2000, 2001 and 2002.

   Dechow, P.M., Hutton, A.P., Meulbroek, L., et R.G. Sloan, "Short sellers, fundamental analysis and stock returns", Journal of Financial Economics, 61, 2001, p. 77-106.

   Desai, H., Ramesh, K., Thiagarajan, S.R., et B.V. Balachandran, "An investigation of the informational role of short interest in the Nasdaq market", 2001, Journal of Finance.

   André Gosselin

 
 
 
Copyright ©2004-2019 Agnosoft