“Imagine for a moment that a friend of yours collects rare coins and you have the view that those coins are going to go down in value. So the way that you would short those coins is to call your friend and say, can I borrow a few of your coins? And he says sure, and you borrow the coins. You then sell them, for the $1000 each that they sell for in the market at the time. And then you wait for them to drop in value, and you turn out to be right and the coins dropped in value to $500. You go back into the market and you buy them back for $500. You have sold them for $1000 and you have repurchased them for $500. You have made $500 on each coin. And then you return the coins to your friend. Your friend is in the same place he was when he started and he has the same coins that he started with. You might actually have to pay him something for borrowing the coins. He has loaned them to you, so you might pay him an interest rate. He is happy because he has made an interest rate lending you the coins. You have made money profiting from the decline in the value of the coins. And that is short selling. That’s when it works”.
The quote was from the fantastic documentary that you can find on Netflix called Betting on Zero. This details the famous short of Herbalife by Ackman and his fund. If you have not seen that documentary I would recommend that you get on to it.
When should one sell short? I think the wrong reason is for valuation. Especially short selling a company that is fundamentally a good company but has a high valuation. That can work of course, and more often than not it probably does, eventually. But it can also go horribly wrong. Imagine if you had shorted Amazon and stayed short Amazon because of valuation reasons. There is the old saying that the market can stay irrational longer than you can say solvent. And in that example, the market was not irrational because Amazon probably did not turn out to be overpriced at all.
I think there are two scenarios where you should consider shorting a stock. The first is that if you figure out something fraudulent is going on. Or does not even have to be fraudulent, but something where there is something systemically wrong with a company that just cannot justify the price where it is trading. It has to be something where there is a catalyst or where it is just built on a pack of cards. One can think of examples like CBL Insurance in New Zealand, or Get Swift in Australia, they would have been good shorts. Or imagine if you had figured out something was up at Enron back in the day?
Perhaps the other time to do it is when a company is no longer sustainable in its industry, or at least no longer sustainable with the same competitive advantage as it used to have. I think of examples in the United States such as Gamestop or Sears as an example. I also remember the example of HMV from when I was living in the UK. Of course, this is fraught with danger as well because you do need to understand valuation a bit more.