Investors Need to Take Long View of ‘Short-Selling’

Stocks’ October rally is slicing into gains of Wall Street’s “short-sellers,” who until now have been among the year’s hottest money managers. But don’t count them out too quickly: If you see the ‘90s as the decade of the stock picker, short-selling’s Golden Age may yet lie ahead.

The shorts, who make a living finding stocks that are poised to drop rather than those ready to soar, had racked up double-digit gains in the nine months ended Sept. 30. Their profits were a good barometer of the market’s underlying weakness.

Among the shorts’ greatest victories this year were stocks such as medical-device maker U.S. Surgical, which has plunged from $134.50 to $69.375, and aerospace giant McDonnell Douglas, which has tumbled from $78 to $46.50. Both were classic short-sale targets--U.S. Surgical for its stratospheric price-to-earnings ratio and McDonnell for its arguably shaky finances.

Overall, a performance index of 18 short-sellers tracked by Centurion Trust Co. of San Diego was up 13.2% in the nine months through September. In contrast, buy-and-hold investors were up 2.5% if they tracked the Standard & Poor’s 500 index.

*

So far this month, however, the shorts are on the run. The NASDAQ market of smaller stocks, a favorite hunting ground for shorts, is rallying on renewed expectations of an economic recovery in 1993. The NASDAQ composite index has jumped 4.5% since Oct. 2, while the S&P; 500 is up 1%.

“Some (shorts) are getting annihilated” by the NASDAQ rally, says Jon Merriman, a short-seller at Beverly Hills-based Curhan, Merriman Capital. Outrageously priced technology stocks had been among the prime targets of short-sellers, and some of those stocks are suddenly in big demand as investors bet on a healthier economy.

The abrupt turnaround in NASDAQ issues illustrates the danger in short-selling: Potentially limitless losses if you’re wrong. In a short sale, you borrow stock from a brokerage and sell it on the open market, betting the market price will soon drop. If you sell at $40 and the stock’s price falls to $30, you can repay your stock loan by purchasing new shares at $30. Your profit thus is $10 a share.

But if you sell short at $40 and the stock’s market price jumps to $60, you’re out $20. And your losses would continue rising with the market price until you buy new shares to repay your loan.

Last year, many short-sellers suffered horrendous losses of 30% or more as the stock market rocketed, lifting even lousy stocks that the shorts had logically targeted as losers.

This year, Wall Street has been much more rational toward most stocks, the latest NASDAQ rally notwithstanding. And that plays into the hands of the shorts, many of whom perform painstaking research to identify high-flying stocks that don’t deserve their current prices.

The debacle of 1991, in fact, may this year have emboldened some short-sellers who otherwise might have given up on targets that they knew in their hearts were overpriced--for example, biotech and other medical stocks, which finally cracked this year after a three-year rally that pushed prices to astronomical levels relative to earnings.

“The shorts who are doing well this year are the ones who got waxed last year,” says Steve Kibbey, a short-seller at Centurion Trust. Many of those managers decided to go for broke in 1992, figuring the only way to keep clients after last year’s losses would be to score huge this year, Kibbey says. Meanwhile, short-sellers who backed away from the most overpriced stocks earlier this year have regretted their conservatism, Kibbey says.

*

What’s cheering many short-sellers this year--and their clients, who include many main line institutional investors eager to make a buck--is simply that stock-picking again is working both ways: You’re being rewarded either for buying genuinely good stocks that are reasonably priced, or for short-selling stocks that are overpriced, bad businesses or outright frauds.

Ironically, short-selling’s renewed attractiveness may be self-defeating in the near term. The number of NYSE shares sold short is at an all-time high, as more investors take a bearish view of the market. If the October rally continues, amateur shorts could panic and cover their positions on the open market--adding to the rally.

Still, all indications are that the ‘90s will belong to the smartest stock pickers, longs and shorts. The market’s pulverizing of many overpriced stocks this year has renewed short-sellers’ willingness to maintain their bets. Many shorts now see restaurant stocks and computer-networking issues (such as Novell and Cisco Systems) as areas ripe for a fall--though the pros caution that only the patient should play these.