Long Bull Market Stomping Short Sellers’ Profits : Rally, Takeover Speculation Keeps Lifting Stock of Both Sound and Mediocre Firms

Short sellers are having a tough time in the stock market this year, and Kathryn Staley, an investment adviser in Atlanta, has a pithy if surreal explanation why:

“Trash is levitating,” she says.

The market’s strong rally this year--up 25% so far, as measured by Standard & Poor’s 500 index--is lifting stocks of both sound companies as well as mediocre ones whose prices might otherwise be tumbling into oblivion. That’s making it hard for short sellers--investors who bet that stocks will fall in price--to make money, even if they’ve shorted companies that are lousy performers.

Indeed, most “shorts” are having a mediocre year at best and are struggling to just stay even for the year.

“Most short sellers are anywhere from break-even to down 10% to 15%” in terms of their return on invested capital, said Staley, who advises clients on selling short. By contrast, short sellers were posting average returns of 20% or more at this point last year, she said.

“I don’t know any short sellers that are making money,” agreed Neil Dolinsky, a partner of Dunnavan Dolinsky & Weeden Leuthold, a Minneapolis partnership that sells short for institutional clients.

Harcourt Brace Jovanovich is the kind of stock giving Dolinsky and other shorts fits this year. The Orlando, Fla.-based publishing, insurance and theme-park concern took on more than $2 billion in debt to fight off a takeover bid by British publisher Robert Maxwell two years ago and now is trying to sell assets to survive.

Dolinsky, confident Harcourt’s stock would tumble, shorted the stock twice in recent months. Instead, Harcourt this year has climbed to about $16 a share from $9, saddling Dolinsky with losses.

But he isn’t giving up. Dolinsky shorted Harcourt again this week.

“We’re still convinced we’re going to be right about it,” he said. “Staying power is the name of the game.” Maybe, but his $20-million short-selling fund for institutional clients is down 9% since the fund was established in mid-June.

Short sellers have been burned by several other stocks that did not plunge as they expected. They wrongly predicted that L.A. Gear, a trendy footwear maker, would not live up to strong sales projections and that disappointed investors would dump the stock. Instead, L.A. Gear has kept growing and its stock has tripled this year, closing at $74.75 a share Thursday.

Texas Air has been another sore point with the shorts. Frank Lorenzo’s debt-plagued company put its Eastern Airlines unit into bankruptcy protection and Texas Air is trying to sell some assets to pay off its debt, yet its stock closed Thursday at $18 a share, up from about $12 at the start of 1989.

“It’s been a very tough year,” said Robert Holmes, president of Gilford Securities in Chicago, which manages a short-selling fund of about $10 million. But he, too, is not giving up on his favorite picks. He continues shorting Texas Air.

Unlike traditional investors who go “long” and buy a stock hoping it will climb in price, short sellers first borrow shares from a broker and then promptly sell the stock. Then they wait for the stock to drop in price, when they can repurchase the shares, return them to the broker and pocket the difference in price (less trading commissions).

But selling short is risky business. Whereas a stock bought long can only drop 100%, a shorted stock can double or triple in price, making the short seller’s risk unlimited. Also, it might be months or years before the price of the shorted stock finally drops. It’s not uncommon for short sellers to wait two years or more before “covering” a position, that is, buying back the stock. In the meantime, if the stock price goes against them, they would face “margin calls”--demands for more cash--from the broker who loaned them the stock.

To be sure, there have been stocks that even the bulls have finally sold off, putting the short sellers in the money. Two examples: Integrated Resources, a once high-flying tax shelter syndicator that defaulted on its bank debt this summer, and Jiffy Lube International, a fast-growing chain of auto-service stores that faced a cash crunch earlier this year. Holmes said he made a nice profit shorting that pair of stocks.

Began in ’82

Overall, however, short sellers said they’re having to wait longer than normal to profitably cover their positions because of the current bull market.

“Some of these stocks just won’t die, they seem to have multiple numbers of lives,” said Joe Feshbach, who with his brothers Kurt and Matt and partner Tom Barton are considered the leading short sellers in the nation. Their Palo Alto firm, Feshbach Bros., which manages a $400-million portfolio, is down 3% so far this year, compared to a 22% gain in 1988, he said.

The Feshbachs became prominent after proving that short selling, if done correctly, could earn big profits in nearly any market. They began shorting with $200,000 in 1982, just as the historic bull market was getting under way, yet they managed to double or triple their money in some years. They also specialized in finding short candidates where corporate fraud was involved.

One of their biggest scores was shorting ZZZZ Best, Barry Minkow’s Reseda-based carpet cleaning company that collapsed due to insider fraud in 1987. The company had a stock market value as high as $200 million, but virtually all of ZZZZ Best’s reported sales turned out to be phony.

Convinced the company was lying about its remarkable sales growth, the Feshbachs shorted the stock at $10 a share, then watched as the shares became worthless--except to them and other short sellers.

Because short sellers thrive on corporate disasters and financial failures, many executives and traditional investors find the shorts repugnant. Short sellers also have been accused of spreading rumors to send stocks lower. The shorts counter by saying executives need only to bolster their companies’ performances to keep them at bay.

Particularly Hamstrung

“The guys who have been the most critical and the most hostile toward short sellers have almost without exception had the most to hide,” Joe Feshbach said.

A bull market naturally makes the shorts want to hide. But this year many short sellers claim to be particularly hamstrung because lots of companies they consider to be losers have been bid up nonetheless, largely because takeover speculation has become so widespread that even struggling companies are attracting interest, they said.

“This is the most frustrating market for me since I’ve been on the short side” starting in 1985, said Jim Chanos, owner of Kynikos (Greek for “cynical”) Associates, a New York money management firm. “There’s so many deal makers, so much capital, that the criteria (for buyouts) has just gone down.”

But despite striking out on many stocks this year, the shorts are still anxious to come to bat. Short interest in August--that is, stock that had been sold short but not yet repurchased--totaled 554.5 million shares on the New York Stock Exchange, just shy of the record 556.3 million reached in April.

Even at those levels, short selling comprises just a fraction of total trading volume. But the short-interest level signals that selling short is not falling out of favor despite the stock market’s surge.

The rally, in fact, could be setting the stage for the short sellers’ comeback. The market’s rise is making an increasing number of stocks overpriced relative to their business prospects--and thus ripe for a collapse that would cheer the shorts.

Said Feshbach: “It’s a difficult market. But there’s a lot of merchandise available.”