Research Frontiers (REFR) is, if not a fraudulent company, certainly a failed company. Forty years since it was founded it has no product, 14 employees, revenues below $300k per year, and yet it has a market cap of $200 million. Of the company’s 14 employees, 4 are technical/research employees. Only one of those employees has a PhD (in chemistry). (See the company’s 10k for details; this information is around page 10, after the list of licensees). This is not what you want to see in a technology start-up.
Research Frontiers owns the technology to tint glass and plastic by running an electric current through the material. One problem with the technology: the electricity is required to keep the glass clear. This minimizes the possible uses for Research Frontier’s tinting solution for safety reasons: it would be unfortunate for a car’s engine and battery to die, causing the windows to all go dark. Also, this makes it harder to use the technology in highly portable applications such as glasses (0.6 watts per square foot are required to keep the glass clear). The glass has also been derided as not becoming clear enough when the tinting is off. Research Frontier’s R&D spending is minuscule and it competes with companies much larger than itself that already have products on the market (such as the tinting solution in Transitions(TM) glasses, which is a passive system that darkens in response to UV light).
I recommend pursuing the archives at Asensio.com, detailing Manuel Asensio’s battle against REFR (he was/is a well-known short-seller, although I should note that he has his own detractors). To see the bull argument, see Gene Marcial’s short column at BusinessWeek. For a more nuanced view, take a look at this Forbes column from 2003.
If you value your money, stay away from Research Frontiers. Also, note that while I often profile bad investments, I do not recommend engaging in short selling; it is very risky.
Disclosure: I am not short REFR. I have never smoked REFR either. My disclosure policy once smoked a chocolate cigar but it did not inhale.
The great stock speculator, Jesse Livermore, was known primarily as a short seller of stocks. He was even blamed by some for the stock market crash of 1929. While he made money shorting stocks (thus profiting when their prices decreased), he also speculated on the long side as well. His story is a great story, and he has many tips that are useful even for people who do not share his extreme risk-seeking behavior.
I highly recommend Edwin Lefevre’s fictionalized account of Livermore’s first two decades in the market, Reminiscences of a Stock Operator. Of course, we would all be wise to remember that there is much more to life than the market. Livermore committed suicide in 1940; his suicide note read: “My whole life has been a failure.”
I do not think shorting stocks is a good idea for most people. It is very easy to quickly lose a lot of money shorting stocks. However, shorts can tell us a lot, and it behooves us to understand and pay attention to stock shorting.
First, let’s start with a simple definition: shorting a stock involves borrowing that stock from someone who owns it and immediately selling it, with the promise to buy back that stock in the future. Someone who is short a stock makes money if the stock decreases in price.
Why would anyone go short? If a stock is highly overvalued, or a company is run by complete idiots or a kleptomaniacal management, it would be wise to go short and benefit from the stock eventually falling. However, shorting a stock exposes you to infinite risk–if the stock more than doubles, you will lose more money than you invested. Going long, on the other hand, is much less risky, since you can only lose the money that you originally invested. Another problem with shorting is timing: for example, look at the chart for Cheniere Energy (LNG). Cheniere has not yet made any money from its main business, liquefied natural gas receiving terminals, and there is a significant risk of the company going bankrupt before it ever makes money. But with the increase in natural gas prices, the stock price shot up drastically in 2004. This led to a number of people shorting the stock, and they made plenty of money as the stock fell below $28 (from a high of $40).
Since that time, however, Cheniere’s stock has gradually bounced around, bringing it back up to its previous highs (and back below again). All that happened despite no fundamental changes in Cheniere’s outlook. Another interesting company has been Overstock.com (OSTK). While shorts have made money in this stock over the last year, and the company still looks overvalued, there is no reason the stock price could not shoot up again, giving the shorts some huge losses.
One last problem with shorting is that it requires betting against the long-term trend of the market. Over time, most companies become more profitable, and the U.S. economy as a whole grows at about the rate of 3.5% each year if we subtract inflation. If we figure in an average inflation rate of about 4% per year, then we add those two rates together with the average dividend rate (historically) of about 2.5% to get the average growth in stock prices per year: about 10%. In the long run, shorts will lose. In the short run, however, the market is far from perfect, and a savvy short can profit.
Just for your information, there is another way to profit via a stock’s declining price. That is via the use of put options. They have the benefit of reducing risk to the amount used to purchase the put, while also increasing leverage. On the other hand, options have a limited lifespan, so if you buy an October put and the stock doesn’t decline until November, then your put will expire worthless.
So why do people short sell? There are several different strategies to short selling. The classic hedging or market-neutral strategy involves buying the stocks of good companies in an industry and then selling short the bad companies. This same strategy can be used with all stocks in the market–buying the best and selling the worst. This way, a money manager can make profits even if the market as a whole does not go up. An astute manager would be net short (have more short than long positions) if he thought that the market should decline, and be net long if he though the market should go up.
Others, who sell options, may wish to short a stock so that their market risk is neutralized. A seller of call options would short the underlying stock to remain market-neutral, whereas a seller of puts would buy the stock. Other investors (including hedge funds and mutual funds) may choose to short sell some stocks as a kind of insurance for their (much larger) long positions.
So, anyway, to the main point of this article: why should everyone know about shorting? Simply put, short sellers tend to be the most sophisticated investors and speculators; many hedge funds use short-selling strategies. The short interest ratio is easily available for most stocks, and we can find it for free at Yahoo Finance. For example, see the short ratio of XJT (it is under share statistics). It is currently at 29%. For most companies, the short percentage will be well under 1% (such as for GE). Besides using Yahoo Finance, you can also find short interest from E*Trade (even if you are not a customer); they report the last four months of short interest. For Nasdaq stocks, visit the Nasdaq website to find the number of shares short for a given stock.
For comparison, check out the short ratios of GM (11%) and British Petroleum (BP) (.1%). So how reliable and how useful are short ratios? For any one stock, they are not a very reliable indicator of how the company is doing or where the stock will go. In general, however, stocks of companies with high short ratios (over 2.5%) tend to do worse than stocks of companies with low short ratios. If you wish to read further, I suggest the following article: Short-sellers, Fundamental Analysis and Stock Returns, by Dechow, Hutton Meulbroek, and Sloan.
A stock will tend to do poorly if it is overpriced or if the underlying company is doing poorly. Thus, short ratios will tell us whether some sophisticated investors think a company is doing poorly or if its stock is overvalued. If we are buying too many stocks with high short ratios, we are probably doing things wrong. It is important to remember that as value investors, we will often buy stocks selling at lows. These stocks may have been overpriced or fairly priced, but they would by definition be great candidates for shorting. Therefore, it does not surprise me if a stock I find attractive has a high short ratio.
What is important is that as the stock decreases in price and becomes a better value, the short ratio should decrease. So if I am tracking a stock that goes from having a 15% short ratio to a 5% short ratio, then there are a number of sophisticated investors who believe that the stock is no longer overvalued. Conversely, if a stock has a short ratio that is increasing considerably, we should be wary about any problems that the company may be having.
If you are interested in how short interest relates to the market as a whole, I suggest the academic paper by Lamont and Stein: Aggregate Short Interest and Market Valuations. The punchline is shown by the figure at the end of the paper: short interest does not really tell us that much. If anything, a low overall short interest level indicates stock market losses and a high level predicts stock market gains!
Disclosure: I hold no shares (long or short) of any of the companies mentioned in this article. See the disclosure policy.
Chet Currier wrote a worthwhile article on bloomberg.com about how large-cap stocks, despite low valuations, still have not turned around and performed well, whereas small stocks continue to outpace the market. This is the kind of thinking that indicates to me that it is time to buy large cap value stocks. In the long run, what drives stock returns is valuations. If you take a look at Vanguard\’s various index funds, you will see that the large cap value fund has an average P/E of 14, versus average P/Es above 19 for mid- and small-cap value funds. In a perfectly efficient market, large cap stocks should have somewhat higher valuations than small stocks because they tend to be less risky.
So if you want an easy investment right now, invest in Vanguard’s VIVAX (large-cap value) fund, or the equivalent ETF, VTV. Then just hold on to that for the next 5 years and watch as you outperform the market.
I do not discuss growth index funds, because value is always going to be a better bet over the long term.
Large-Cap Index Funds and their P/E ratios
S&P 500 index fund (VFINX) - 17.0
Dividend Appreciation index fund (VDAIX) - 17.7
FTSE Social index fund (VFTSX) - 18.5
Growth index fund (VIGRX) - 21.2
Large-Cap index fund (VLACX) - 17.3
Total Stock Market index fund (VTSMX) - 17.9
Value index fund (VIVAX) - 14.7
Mid/Small Cap Index Funds and their P/E ratios
Extended Market index fund (VEXMX) - 23.2
Mid-Cap index fund (VIMSX) - 19.5
Small-Cap Growth index fund (VISGX) - 26.5
Small-Cap index fund (NAESX) - 22.5
Small-Cap Value index fund (VISVX) - 19.7
Disclosure: I own shares of VIVAX, I love Vanguard, and my disclosure policy has a P/E of 8.
Buying high-quality wine actually can be a very good long-term investment. See the article at Bloomberg.com. An academic paper discussing this (serving as the basis of the above article) is available for free download through SSRN. High-grade wines have a great return with relatively low volatility. The returns are also not very correlated with the stock market, so wine would be a great way to diversify.
The problem? Storing the wines requires good conditions (such as a good, cool, dry cellar or a wine cooler). Also, selling the wines would rack up huge commissions when they are auctioned off. And if you do not have a large collection it would be hard to sell the wine.
This is a perfect type of investment for a mutual fund or ETF. There is one hedge fund that deals with wines, but its minimum investment is high (100k euros) and its fees are steep as well.
Of course, the other way to invest in wines is to buy them and drink them and consider that in an investment in happiness! Yesterday I opened up a bottle of 2005 Morgon (a good, fruity red Beaujolais with some complexity and terroir). My return on investment was immeasurably large.
Disclosure: I like wine and I make it as well. My disclosure policy likes wine as well.
If you (or friends, or family) wishes to invest but does not wish to spend 30 hours a week investigating stocks, please see the following page (also linked under Pages on the right of the homepage of my blog).
I am generally not a fan of stock trading games or contests. However, I do like the Motley Fool’s CAPS. I have gotten a few successful short pick ideas from the game, and I have learned of some great stocks from a long perspective as well. In fact, I found Tecumseh (TECUA) on CAPS and was about to buy it before it shot up 50% in one day as it was upgraded and it sold some assets.
CAPS is a good way to try out a new way of picking stocks or a way to find out what others think about stocks you like (dislike). CAPS players are rated on the quality of their picks, and not surprisingly, I am highly rated. In fact, I am currently rated #53 out of 33,000 people on CAPS. Not bad, eh? See me on CAPS.
Okay, I was a little bored. This is the theme song of my short selling today. To the tune of “Catch a Falling Star.”
Short a falling stock and put it in your pocket
Hopefully it will fade away.
Short a falling stock and put it in your pocket
You can buy to cover some day.
For the market may crash and wipe out all the bulls,
Some bloody day!
Just in case you want to profit,
You’ll have made money on the short side!
Short a falling stock and put it in your pocket
Hopefully it will fade away.
Short a falling stock and put it in your pocket
You can buy to cover some day.
For when the Dow and Nasdaq are fallin’,
An’ that’ll come some way!
Life will feel a whole lot better,
If you were shorting stocks that day!
Short a falling stock and put it in your pocket
Hopefully it will fade away.
Short a falling stock and put it in your pocket
You can buy to cover some day.
original lyrics:Catch a falling star an’ put it in your pocket,
Never let it fade away!
Catch a falling star an’ put it in your pocket,
Save it for a rainy day!For love may come an’ tap you on the shoulder,
Some star-less night!
Just in case you feel you wanna’ hold her,
You’ll have a pocketful of starlight!
Catch a falling star an’ ( Catch a falling . . . ) put it in your pocket,
Never let it fade away! ( Never let it fade away! )
Catch a falling star an’ ( Catch a falling . . . ) put it in your pocket,
Save it for a rainy day! ( Save it for a rainy day! )
For love may come and tap you on the shoulder,
Some star-less night!
An’ just in case you feel you wanta’ hold her,
You’ll have a pocketful of starlight!
( . . . pocketful of starlight! ) [ hum in time ]
Catch a falling star an’ ( Catch a falling . . . ) put it in your pocket,
Never let it fade away! ( Never let it fade away! )
Catch a falling star an’ ( Catch a falling . . . ) put it in your pocket,
Save it for a rainy day! ( Save it for a rainy . . . Save it for a rainy, rainy rainy day! )
For when your troubles startn’ multiplyin’,
An’ they just might!
It’s easy to forget them without tryin’,
With just a pocketful of starlight!
Catch a falling star an’ ( Catch a falling . . . ) put it in your pocket,
Never let it fade away! ( Never let it fade away! )
Catch a falling star an’ put it in your pocket,
Save it for a rainy day!
( Save it for rainy day! ) Save it for a rainy day!
Sung by Perry Como (see him on Youtube here)
Music and Lyrics by Lee Pockriss and Paul Vance
Glaser and Weber just released a paper with the above title on SSRN. I urge you to download and read it. They examine the performance of 215 online investors over the past 4 years and find that the investors have no clue whatsoever as to how much money they made or lost. At the extreme, one investor who thought he had lost 50% per year had actually gained 2% per year. Another who thought she had gained 120% per year had lost 3% per year.
There was literally no correlation between the returns investors thought they had made and the returns they actually made. There was a tendency for those with better performance to be more accurate in assessing their past performance (they were better calibrated). This is a logical outcome–those investors who know how they did were more likely to allocate money to strategies that worked. So if they knew that they tended to lose money speculating in tech stocks, they would know to switch to something safer (index funds or blue chip stocks). That is why you should know your performance.
I am the poster boy for the importance of tracking performance. Since I started seriously investing in 2005 I have done all sorts of things–day trading, options, shorting stocks, speculating in gold, quantitative investing, value investing, and raw speculation. I know after tracking my performance in detail on Icarra that most of these things were not worthwhile. While I made a lot of money in gold I did not know what I was doing, so it made sense to get out. I lost money in day trading and got out with minuscule losses after only a week. I have made money shorting stocks. I have broken even on my options trading, mostly because I have gotten fairly good at shorting stocks and I used puts on a few stocks this summer that I could not borrow the shares to short. I have lost a lot of money in various stock speculation. When I have focused on finding and understanding good value stocks I have on the whole made money, doing slightly better than the market. My quantitative investing performance has been pretty darn spectacular.
So now that I know how I have performed, what will I do about it? I have forbidden myself from rank speculation in stocks or options. I have increased my short activity. I have limited the number of individual stock positions I pick for my value investing portfolio, increasing the size of each position, so that I can focus on better understanding each company. I have also drastically increased the portion of my portfolio that I allocate to quantitative strategies, both long and short.
So take a look at your performance. If it is okay, you may want to allocate more money to those strategies that are more profitable and less to those that are less profitable. If your performance is dismal, you may want to just stick all your investments in index funds. Remember, if you index, you can expect to outperform 80% of all investors, while spending a lot less time thinking about your investments.