Short Sellers Circling Net Stocks

A day after they notched another round of mind-boggling gains, a host of big-name Internet-related stocks fell hard Tuesday. So is it finally time to “short” these shares?

When investors short a stock, they’re wagering that the price is about to drop. And given the dizzying--some say ridiculous--ascent of Internet stocks lately, it’s natural to wonder whether now’s the time to bet that the group will tumble.

Indeed, short sellers are circling Internet stocks in huge numbers. But shorting carries big risks. The most obvious is the danger of losing money if the stocks keep rising. Anyone who shorted Internet search vehicle Yahoo Inc. at $100 a month ago, for example, would be miserable today with the stock at $191.

“I think most of the short sellers--and most of the buyers--are from the mental houses,” said Meyer Berman, a longtime short seller in Boca Raton, Fla., who, despite his observation, acknowledged that he couldn’t resist on Tuesday shorting an Internet stock that he refused to identify.

When an investor sells a stock short, he or she borrows shares from a brokerage and then sells them on the open market. The investor pockets the funds from the sale, but the shares must be replaced at a later date. Therefore, the investor hopes the stock price falls so that the replacement shares can be bought at a lower price.

If the stock in fact dives, the investor pockets the difference between the higher price at which the initial shares were sold and the lower price at which the later ones are bought, minus commissions.

But if the stock’s market price rises, the investor loses money because the replacement shares must then be bought at a higher price. That can lead to a “short squeeze,” with the unintended effect of driving the stock’s price even higher than it otherwise would be.

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In many ways, Internet stocks are a natural magnet for short sellers. They’ve been on a tear despite nothing more than grandiose business plans at some companies. When the hysteria dies down, the short sellers reason, so will the stocks.

The number of shares sold short--also known as the short interest--jumped between January and June for many Internet stocks. Nasdaq market data show that short interest rose 16% in Yahoo shares, 46% in bookseller Amazon.com and 68% in Lycos, another search vehicle.

Those figures are even more startling when short interest is compared with the number of shares that are publicly traded. Yahoo, for example, has 18.4 million publicly traded shares--and a whopping 5.7 million, or 31%, were sold short as of mid-June. Of Amazon.com’s 18.2 million publicly traded shares, 48% have been sold short.

But the most surprising revelation about the short-interest figures may be this: Even though many short sellers may have been squeezed out of Internet stocks along the way, other short sellers have replaced them. So on a net basis, more shares have been sold in the shorting activity than have been bought back in any short squeezes.

Which suggests that short squeezes in these stocks so far haven’t contributed much to their gains. And that buying by investors betting on higher prices has been the driving force behind the stocks.

Does that mean that major short squeezes could be ahead if the stocks keep rising? Maybe not. Because while short interest has risen, average daily trading volume in Internet stocks has jumped at a far faster rate.

Take Lycos, for example. While short interest has risen 68% to 1.4 million shares from January to June, average daily trading volume has swelled more than fivefold to 1.8 million shares. So if every short position was closed out, the 1.4 million shares that would need to be bought would equal only about three-quarters of a single day’s volume.

“The short interest on these will keep the fire going for a few days if all the shorts were forced to buy, but the huge volume reflects buying on a broader basis,” said Paul McEntire, head of short-selling firm Skye Investment Advisors in Los Gatos, Calif.

That frenzied investor demand for Internet stocks could continue to ruin short sellers’ bets in the near term. But even if you believe the shorts will be proved right, there’s another problem now: It’s tough to borrow these stocks because so many shares have already been shorted. Money manager Jeff Gladstein, for example, has tried to short Amazon.com and K-Tel International for two weeks but has been unable to secure shares.

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Bearish Bets

As Internet bookseller Amazon.com’s shares have rocketed from $10 to $143 over the last year, so has the number of shares sold “short”--bets that the stock price would decline. Number of short sales, in millions of shares, at mid-month:

June 1998: 8.7 million

Source: Bloomberg News