The Art of Short Selling - Wealth With Risk

Short sellers unearth facts from financial statements and from observation to ascertain that a stock is overpriced. Short sellers are information-based traders. Before 1983, no solely short funds existed. Stocks can only go to zero on the way down, but can go to infinity on the way up (reply: I've seen a lot more stocks go to zero than to infinity). Short sellers take greater risk than other investors - they must have strong evidence to support cases for price declines. Becauses reverses are sudden and terrifying, the burden of evidence rests on a solid, careful analysis completed before the stock is shorted.

Short selling is a niche. It is very small relative to the stock market as a whole. The long bias of and in the market creates exploitable inefficiencies for shorters, ie. there are more overpriced stocks than underpriced stocks (Asquith and Meulbroek). Negative earnings surprises affect stock prices to a greater degree than positive earnings surprises, and that effect persists over time. The common wisdom that there is no such thing as one bad quarter has a statistical basis. Stocks become torpedo candidates when very high expectations give way to earnings disappointments.

Short sale candidates cluster in three broad categories:

1. Companies in which management lies to investors and obscures events that affect earnings.
2. Companies that have tremendously inflated stock prices - speculative bubble.
3. Companies that will be affected in a significant way by changing external events. 

The trail signs to look for:

1. Accounting gimmickry: clues that the financial statements 
2. Insider sleaze: inurement, insider sellling.
3. Fad or bubble stock pricing: large price rise over short period.
4. A gluttonous corporate appetite for cash.
5. Overvalued assets or an ugly balance sheet.

The main precept of short selling analysis is bulk. Volumes of disparate facts and observations.

Accounting-based analysis is not difficult to do, but it takes time, patience and a suspension of belief.

The lack of attention by other professional investors to financial details provides the inefficiency in information dissemination that is so central to the short sellers art.

The goal is to identify the tragic flaw in a business long before the company's demise (the death rattle of a company in decline). The art of short selling trains analysts to avoid torpedo stocks or to profit from them.

The main weakness of short sellers is the inability/difficulty in judging the timing of collapse. Short sellers are consistently years too early when they sell stocks. Short sellers fear most a sustained rally in a stock.

How to make money in short selling and how not to lose money by selling are different sides of the same coin.

Short selling is a game of wits with the odds in favor of the analysts who do hard work and think for themselves, who turn jaundiced eyes on what passes for Wall St wisdom.