Long-time readers will know that I recommended consideration of an obscure stock — Calton Homes, symbol CN — about 18 months ago. It subsequently rose from 60 cents to $2.75 or so (this doesn’t happen to me very often), whereupon I wrote that I had begun selling it. But it continued to rise and soon broke $5. That’s when I wrote that, in my view, the lunatics had taken over — day traders who buy something with no idea what it is. (Which was fine by me, because I still had a little left to sell, as I do even today.)

Writes Gordon: “CN was fun buying at $1.00 and selling at $5.00. Buying, holding on, and later selling at a profit or loss is something I’m comfortable with. But what about shorting? Would CN at $5 be a stock to short?”

No.  Short selling is a very tough game to win:

  • All your gains, no matter how long you hold the position, are taxed as short-term. So immediately your winnings, if any, are chopped in half if you are a high-income New Yorker, or by maybe 30% or 35% if you’re a more typical taxpayer. And on the off-chance the stock you shorted pays a dividend (e.g., Philip Morris), you have to pay the dividend, rather than receive it. (Think of short-selling as the anti-matter of finance. Everything is backwards.)
  • A lot of people are working hard to see you fail. They are the management of the company, who really, really don’t want to see the stock crater. Often you will be right and it will crater. But sometimes they find a rabbit to pull out of the hat. Look at a company like CompUSA — CPU — that savvy investors, who had done their homework, were shorting at 6. Suddenly there is an announcement of a takeover by a large Mexican company, at 10. Ouch. (Four points may not seem like much, but it’s the same as a 60-dollar stock being taken over at 100.)
  • Even when you’re right, you can get killed. Say CN is really worth only 2 or 3. Really. And say that, because of this column, you don’t short it at 5. But say that a week or two from now the lunatic day-traders run it up to 8, and now you can restrain yourself no longer (and you’re thrilled it has that much farther to fall) — and you short it. Now, there’s a slim possibility it’s not lunacy — that ultimately CN’s tiny Internet bets will be truly successful, making actual cash money profits (as was once necessary to sustain a going enterprise) — huge profits, even — and the stock at 8 will appear, with hindsight, to have been a bargain. But forget that. For the sake of this example, we have stipulated that in a year or two CN will be 2. Great to have shorted it at 8, no?

Not necessarily.

Picture it: You’ve shorted it at 8 and, because the market, especially these days, can often go nuts, it rises to 15.

Now what do you do? You either take your loss or hang on — or short more.

But I know you (because I know myself). You are beginning to feel very rotten about this, and beginning to realize that at 8 CN could fall, at most, to 0, making you a taxable profit of $800 on each 100 shares you shorted . . . but that at 15 it could, theoretically, rise to 1,000, losing you $99,200 on each 100 shares . . . and maybe they have some unlikely patent you didn’t imagine that could bring the world to its knees (you begin to think crazy, preposterous thoughts, in other words), and so you . . . well, what do you do?

My guess is that you dig in and hold your ground, but probably don’t short more. And that when the stock gets back down to 8 or 9 you heave a sigh of relief and get out with a small loss. Unless, with the stock back down at 8 or 9, you realize that you were right and the stock really is worth bupkus, so — now that the nonsense has subsided a bit, and you feel that your instincts have been confirmed — you short some more at 9 (wishing you had done so at 15). After all, most professional short-sellers wiol tell you that the biggest mistake amateurs make is shorting too early (that has certainly been my story), and that you are far better off shorting after a stock has broken down.

But now it goes back to 15 (it wasn’t supposed to do that!), except that now you’re short twice as much, and even if your broker doesn’t force you to cover your position at a loss (because the assets in your account are insufficient to meet the margin requirements for maintaining this short position), YOU’RE ACTUALLY HAVING TROUBLE SLEEPING. Which is nuts — life is too short to get all stressed out over this stuff — so you should cover it, but that’s even more nuts, because it will be $2 in a year or two, so why take a big loss instead of a nice profit? And around and around you go, tossing and turning, and now it hits 19¼ — in part because of all the short-covering (short-sellers forced by nerves or margin calls to buy CN to cover their positions) — and you cover half. And then when it gets back to 9 you cover the rest, or most of the rest, vowing to short it again when it gets back to 19, but it never does, it goes gradually to 2, just as you always knew it would.

YOU WERE RIGHT! And it cost you $13,000. (Or whatever: I don’t know how many shares you shorted, in part because you were too embarrassed to tell anyone.)

So is CN overpriced at 5? Probably. Do I think you should short it? Absolutely not.

And the same holds true for hundreds of other overpriced stocks these days.

 

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