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| Source: Bankrate |
Table of Contents
- Introduction
- What is Short Selling?
- Develop an Investigative Mindset
- Identify Promising Short Candidates
- Gather Public Information?
- Look for Red Flags in Financial Filings
- Search for Lawsuits and Controversies
- Scrutinize Marketing Claims
- Analyze Competitive Landscape
- Assess Management and Corporate Culture
- Talk to Industry Experts and Insiders
- Build Financial Models and Valuations
- Develop a Strong Short Thesis
- Plan your Entry and Exit Points
- Manage Risks and Hedge Your Position
- Know the Rules and Limitations
- Continuously Monitor Your Shorts
- Conclusion
- FAQ
Introduction
Short selling can be an extremely lucrative investment strategy, but it requires an enormous amount of research and analysis to identify overvalued companies poised for a fall. Professional short sellers have cultivated research skills that allow them to spot red flags and build compelling short cases well before the market corrects overinflated stock prices.
This comprehensive guide will explore the investigative strategies used by successful short sellers to find promising short opportunities while avoiding costly mistakes. Whether you’re looking to short stocks for the first time or take your abilities to the next level, these proven research tactics can help you generate profits by betting against overhyped, struggling, or fraudulent companies.
What is Short Selling?
Before diving into research techniques, it’s important to have a solid grasp of what short selling is and how it works.
Short selling involves borrowing shares of a company from a broker and immediately selling them at the current market price. The short seller profits if the stock price declines, allowing them to repurchase the shares at a lower price and return them to the broker, keeping the difference as profit.
Essentially, short sellers succeed when a stock goes down in price. They hope to identify overvalued companies and anticipate downward corrections in stock prices.
However, short selling also comes with substantial risks, including essentially unlimited losses if the stock keeps rising. That’s why thorough research into short candidates is so critical.
Develop an Investigative Mindset
The keys to success are having an investigative, skeptical mindset and determination to leave no stone unturned in your research.
Rather than taking things at face value, analyze information from all angles to uncover red flags, inconsistencies, or fraud that point to underlying problems. Question everything and don’t rely solely on management’s rosy portrayals.
Be willing to go above and beyond superficial research and dig deeper to find the real story. Think like a detective looking to crack a case through piecing together clues.
Maintain high standards for evidence and have a healthy sense of skepticism instead of believing everything you read. Scrutinize information sources and motivations before incorporating insights into your analysis.
Identify Promising Short Candidates
With the right mindset, you can begin scanning the market for signals of overvaluation.
Some starting points include:
- Recent IPOs with sky-high valuations
- Unproven companies with shaky fundamentals
- Industries where competition or disruption looms
- Highly acquisitive companies showing signs of trouble
- Stocks hitting 52-week or all-time highs
Look for patterns like rising short interest, high valuations relative to peers, slowing growth, insider sales, or frequent management changes.
Focus your efforts where due diligence can yield the largest rewards. Stay objective and don’t get married to any positions.
Gather Public Information
The next step is gathering as much public information as possible about short candidates:
- SEC filings — 10Ks, 10Qs, proxies, and disclosures
- Earnings call transcripts
- Industry reports
- Press releases and news
- Marketing materials
- Social media and online forums
- Glassdoor reviews and job listings
- Public records — lawsuits, patents, real estate
Gather both current and historical information to understand business trajectory. Look for changes in disclosures or financial metrics over time.
Screen for patterns that signal problems ahead.
Look for Red Flags in Financial Filings
Analyzing financial statements is essential to avoid value traps and identify precarious financials. Cross reference SEC filings with earnings calls and investor presentations to catch inconsistencies.
Watch for:
- Missed earnings guidance
- Profit margins declining faster than competitors
- Increasing accounts receivables or extending payment terms
- Drawdowns on credit facilities
- Supply chain disruptions or loss of key partnerships
- Increased capital expenditures and R&D costs
- High executive compensation relative to peers
- Excessive stock promotions or management hype
These could suggest underlying financial strains despite outward appearances.
Search for Lawsuits and Controversies
Lawsuits, regulatory actions, and controversies can reveal risks not priced into a stock. Search state and federal court databases, regulator press releases, and news sources.
Look for trends like:
- Consumer lawsuits over product issues
- Employment discrimination or harassment allegations
- Whistleblower complaints
- Patent/IP disputes or thefts
- Product recalls or safety issues
- Federal investigations into marketing or billing practices
- Environmental violations
Document all cases to assess legal liabilities and reputational damage.
Scrutinize Marketing Claims
Company marketing provides clues to evaluate product positioning and sentiment.
Analyze claims around:
- Total addressable market size
- Market share
- Growth trajectories
- Customer testimonials
- Competitive advantages
Verify against independent data sources. False or misleading claims may signal desperation and mask weaknesses.
Analyze Competitive Landscape
Thoroughly research competitors and substitutes that could disrupt the company’s business.
Gather data on:
- Competitor products, pricing, and market share
- Competitor financial health and funding
- New market entrants
- Substitute products gaining adoption
- Related patents and IP developments
- Regulatory changes on the horizon
This will reveal threats to growth prospects and pricing power that may not be appreciated.
Assess Management and Corporate Culture
Management shapes strategy and execution. Research backgrounds, qualifications, incentives, and track records.
Look for:
- Inexperienced, unqualified leaders
- High management turnover
- Excessive, equity-heavy compensation
- Questionable related-party transactions
- Lack of skin-in-the-game
- Departures of key personnel
- High salesforce attrition
Also assess glassdoor reviews, social media, and news for cultural red flags like misconduct, discrimination, or dysfunction.
Talk to Industry Experts and Insiders
Connect with former employees, vendors, customers, and sector experts to get an unfiltered view.
Ask probing questions:
- How do internal metrics match external reports?
- Are stated growth rates achievable?
- How satisfied are current customers?
- Are there undisclosed business headwinds?
- How competitive is the product lineup?
- Is executive turnover impacting morale?
This primary sourcing can uncover on-the-ground realities. But document sources and weigh credibility of insights.
Build Financial Models and Valuations
Model out financial statements and valuation based on your research insights. Stress test key assumptions like:
- Growth rates
- Profit margins
- Market penetration
- Customer acquisition costs
- Cash burn rate
Ascertain how financials change under different scenarios. Compare valuations to sector peers. This can reveal disconnects between hype and fundamentals.
Develop a Strong Short Thesis
Synthesize research into a compelling short thesis before taking any position.
A solid thesis should:
- Identify specific downside catalysts
- Assess timing and probability of catalysts
- Detail supporting evidence from various sources
- Explain how the market is mispricing risks
- Estimate potential downside if thesis holds
The goal is an in-depth, 360-degree perspective on overlooked risks to the business.
Plan your Entry and Exit Points
With a short thesis in hand:
- Decide sizing based on conviction level and risk appetite
- Scale in to limit exposure at any one price
- Use options collars or short calls to define exit points
- Set upside and downside price targets
- Plan stop losses in case thesis breaks
Continuously reevaluate as new data emerges. Be ready to change course if fundamentals improve.
Manage Risks and Hedge Your Position
Short selling carries significant risks, including infinite losses if a stock rallies.
Mitigate risks by:
- Maintaining overall portfolio diversification
- Appropriately sizing positions
- Hedging with calls, put options or shorting correlating stocks
- Using hard stops based on fundamentals
- Monitoring short interest and borrow rates
- Planning exit points in advance
Know the Rules and Limitations
Understand regulations, account requirements, and shorting restrictions to avoid violations:
- Uptick rule on short sales
- Locating borrowable shares
- Broker account minimums and margin needs
- Days to cover and short interest ratios
- Hard-to-borrow stock designations
- Short sale blackout periods
Stay up to date on rule changes that could impact tactics.
Continuously Monitor Your Shorts
Keep gathering data and tracking business trajectory after taking a position.
Look for:
- Earnings reports vs. guidance
- Conference call commentary
- Insider transactions
- Short interest fluctuations
- News that confirms or contradicts thesis
- Analyst ratings changes
- Data from supply chain checks or channel sources
Be ready to quickly reassess and exit if odds shift.
Conclusion
With tenacious research, strategic planning, risk management, and continuous monitoring, short selling can unlock highly lucrative opportunities to profit from overvalued stocks.
Follow the investigative strategies used by successful short sellers, such as scrutinizing financials, assessing management, analyzing competitors, sourcing industry intel, and building valuation models.
Develop alternative data streams, verify marketing claims, probe red flags, and piece together risks overlooked by the market. By spotting problems before the crowd, you can reap substantial rewards as flawed market darlings fall.
The risks and complexities of short selling demand rigorous diligence. But those willing to rise to the challenge can land their white whale and short their way to market-beating returns.
FAQ
Q: What tools do professional short sellers use in their research?
A: Short sellers use a wide array of tools, including financial modeling software, alternative data sources, court record databases, SEC filing analysis software, satellite imagery, sentiment analysis, channel checks, and proprietary investigation techniques. Advanced technical skills and financial resources allow pros to access and analyze data individual investors can’t.
Q: How much capital do you need to get started short selling stocks?
A: Most brokers require a minimum account balance of $2,000 — $25,000 to short stocks, as well as having margin access. Beginners should start small to limit risk. Under-capitalization makes it hard to properly size positions and absorb losses.
Q: What risks beyond losing money should short sellers watch out for?
A: Beyond losing money if a stock rises, key hazards include high short interest increasing borrowing costs, regulatory changes restricting shorting, getting caught in a short squeeze, and failing to vet sources. There is also reputational risk as short sellers are often viewed negatively.
Q: What types of companies tend to be most overvalued or commit fraud?
A: Common short targets include unprofitable tech and biotech firms, high-growth companies priced for perfection, serial acquirers, fad stocks, and companies with accounting gimmicks or excessively promotional management. Shorts identify hype and deteriorating fundamentals.
Q: How long does it take to research a company as thoroughly as a professional short seller would?
A: Truly exhaustive diligence on a potential short can take hundreds of hours over several months. Well-resourced hedge funds have large teams to divide up research, modeling, investigating, and sourcing on promising shorts. Retail investors need focus and perseverance to match their depth.
