LA CASA AÉREA, EL ALBATROS

One of the big differences between books that set out to help readers in-vest and books that concentrate on trading strategies is that the latter often

provide great detail on short selling and may treat this technique as an in-tegral part of an overall trading method and strategy. Selling short is the practice in which instead of buying a stock with the hope of selling it later at a profit, a stock is first sold and then subsequently bought back, hope-fully at a lower price than the selling price, thus generating a profit on the trade. The ability to sell a stock that the trader does not own is based on a service provided by brokers whereby a stock held on behalf of other clients is loaned to the short-seller in order for the short sale to be made. At some point the stock that has been “borrowed” in this way has to be returned or, as the old adage has it, “He who sells what isn’t his’n must buy it back or go to prison.”

It should be noted that shorting of large-capitalization stocks and the subsequent buying back of the stocks shorted are not particularly difficult.

Where smaller company stocks are involved, however, those who short them can sometimes run the serious risk of a “short squeeze.” This is a situation where short sellers need to buy back the stock to square their position as the price of the stock is climbing, and therefore going against them, but find that there is simply not enough stock available to meet the demand of all short-sellers wishing to cover. This drives the price much higher still and can increase the short-seller’s losses significantly.

On the face of it, the selling short of large-cap stocks (to avoid the short squeeze predicament) would appear to be a reasonable tool for the short-term trader to generate returns. Some readers looking at our technique may think to themselves that if we can consistently buy stocks from a contrarian perspective, that is when the price is relatively low, and are then able to sell quickly at a profit, surely we could do equally well selling short when the opposite circumstances occur. It would seem only natural for us to spot a stock that is toward the upper level of its 52-week range and then, on a day that both the market and the individual stock have risen, sell it short, wait for the inevitable downturn, and then buy the stock back at a profit.

Unfortunately, selling short is not the mirror image of buying into a long position, and this is for a number of reasons. The most important of these comes from the fact that the general trend of the market over time is upwards. It is for this reason that buy and hold is not in any sense a strategy that we would ever reject out of hand. While not every stock is destined to increase in value and earn a decent return for its holder, com-panies are in business to make a profit and earn a return for their share-holders and most established, well-capitalized companies with good busi-ness models and management, do exactly that. We mentioned earlier that in buying stocks we normally have the benefit of a wind at our backs. This is true for all who are long stocks. For those who go short, however, there is always a similar headwind against them, and so right from the get-go this impairs their odds of success in this kind of trading. The fact that a

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short-seller has to pay out, rather than receive any dividends that are paid on the stock he has sold short, only adds to the negative effect of this head-wind. As if that were not enough for the short-seller to contend with, the practice is also covered by the so-called “uptick rule” instituted by the Se-curities and Exchange Commission (SEC) following the 1929 market crash for which short-sellers were unfairly given much of the blame. The rule stipulates that you can only sell a stock short at the point that its price trend is upwards. This is no different from the way we would want it to be using our contrarian principles should we be interested in shorting stocks, but it does indicate how the dice have been loaded against the short-seller.

There is no equivalent rule on the long side that says that you are only allowed to buy a stock that is going down.

Another reason why selling short is not a good fit specifically for our trading technique is the fact that the short-seller is betting a little against a lot. Should the short-seller mimic our technique on the long side, he may gain $50 to $100 if the stock falls and he takes his profit as we prescribe. But should the stock not fall back and instead climb further, or should the com-pany receive a takeover offer from another comcom-pany, which would likely drive up its price significantly, the losses could be very large indeed—the risk-to-reward ratio is completely out of sync. While our policy is to hold positions that do not quickly make our desired profit, and sometimes even to buy an additional number of shares after the stock has dropped a point or two, such an approach on the short side would be expensive and might wreck the entire trading strategy. Keep in mind that on the long side, the worst that can happen (and it is not very likely if you stick to good, well-established companies) is that your company goes bust and you lose your entire investment. On the short side, however, your risk if the position goes against you and you hold on is theoretically infinite.

Very few people are clever enough to win at the short game. Some like Jim Chanos have become well known Wall Street icons for their skill with this technique. Hedge funds, which have been around for decades, but recently have become one of the most important groups of alternative investment pools operating in the financial markets, have successfully used short selling as one of their trading and hedging tools. For the man in the street and for those we have targeted as our readers, we strongly caution that selling short is much too risky a proposition to consider as part of what we consider our essentially risk-averse trading strategy.

For any contrarian, however, the temptation to engage in at least some limited short selling will be especially strong at times when a very frothy bull market is under way, especially such as the one that became a veri-table bubble towards the end of the 1990s. The problem with taking the plunge with the shorting technique in such circumstances is that no matter how right you may be about the market being in bubble territory and the

inevitability of an eventual retrenchment, the correct timing of your move is extremely difficult to pinpoint as bubble markets can continue to defy gravity for much longer than seems rational or possible. As John Maynard Keynes shrewdly observed, “Markets can remain irrational for longer than you can remain solvent.”

If our warnings on the subject of shorting stocks still do not steer the trader away from this technique, then we suggest that one sector that holds less risk than most for some very limited shorting is the airline sector. This may seem a strange choice, especially as the airlines have at the time of writing been going through something of a consolidation phase, with stock prices rising to reflect the merger activity and speculation on future deals.

(Then again, this is precisely what should make a contrarian considering a short position sit up and take notice.) In a historical context, however, major airlines are a terrible business to be in, with huge fixed costs in aircraft and staffing (and post-9/11 all those additional security measures) that have to be covered whatever the business environment. Airlines are also particularly vulnerable to high oil prices, which spike with unceas-ing regularity and have often helped push the major airlines into the red.

Even though dozens of airlines have come and gone since the passing of the United States Airlines Deregulation Act of 1978, the majors have over the years become adept at rebooting themselves in the bankruptcy courts, with the result that there are still too many of them around to be seriously competitive. This is unlikely to change even after the current merger cy-cle is complete. The airline business is simply too glamorous for new en-trants not to want to come in and there are few barriers to entry in the U.S. market following the 1978 Act. For those that also operate in inter-national skies, the overcrowding of the market is even more daunting as every country wants to run its own, often government-owned or controlled flag-carrier, whatever kind of sinkhole for taxpayers’ money that might rep-resent. There have been a few exceptions (such as Southwest Airlines) to the remark usually credited to Virgin Atlantic Airways founder Sir Richard Branson that “the best way to become a millionaire is to start as a billion-aire and then buy an airline.” But Warren Buffett probably had the measure of the intrinsically poor quality of the airline business when he made this wry comment; “If I’d been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough—I owe this to future capitalists—to shoot him down.” This came from the same investing genius who struggled mightily with an investment in US Airways that led him to quip in 1997; “Those who have watched my moves in this investment know that I have compiled a record that is unblemished by success.” All told a strategy of selling short a big airline company such as AMR Corp. (owner of American Airlines, stock symbol AMR) or Con-tinental Airlines (CAL) when oil prices are relatively low and buying the

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stock back when the inevitable oil price rise comes around and depresses the stock might work well for someone determined to try his luck with short selling. Again, we ourselves do not recommend this risk-laden tech-nique to anybody. Indeed, as we put the finishing touches to this chapter, the salutary lesson of what can go wrong with even a well-thought-through trading strategy on the short side was made apparent when rumors sur-faced and were reported on in Business Week that British Airways and Goldman Sachs were considering a joint bid for AMR. The alleged target stock jumped almost 5 percent at market open on February 16, 2007. It sub-sequently appeared that such a combination might be fanciful, especially as current rules limit foreign ownership of any U.S. airline’s voting stock to 25 percent. But the simple fact that it could be aired as a serious possibility shows that shorting, even of an airline stock, is always a risky strategy.