As a publisher of investment advice, I usually avoid telling readers to "short" stocks.
Shorting a stock is the opposite of buying a stock. Instead of profiting as a stock rises, shorting allows you to profit when a stock falls.
A financial publisher's job is to provide products and recommendations that people want. Bungle this and you go broke in a hurry. Most of my readers don't want short sales. They see betting on falling stocks as unpatriotic. I disagree. It's healthy for an economy to let unproductive businesses fail. This clears out dead wood and allows capital to flow toward productive businesses.
Also... most investors assume shorting stocks is riskier than buying stocks. Again, I disagree. In fact, given the ideal setup,shorting stocks can be the safest bet in all of finance. And given the declining state of our economy, knowing how to short stocks will provide your portfolio with an outstanding "wealth hedge."
You only buy a stock when your analysis convinces you its shares are worth more than their current price. However, there's a wide range of potential future values. Nobody knows exactly what a stock is worth at any given point in time. Dozens (if not hundreds) of variables go into figuring out the appropriate price of a stock. And the future price is an even greater unknown.
On the other hand, when you're dealing with highly indebted, deeply distressed equities, you can know – as a matter of fact – that the current intrinsic value of the equity is precisely zero. And if you study debt covenants and bond-repayment schedules, you can even figure out exactly when a company is most likely to file for bankruptcy.
If a company's debts are greater than its assets, you know for certain a bankruptcy filing will cause the stock to trade all the way down to zero. Nothing is left to chance. You know the stock isn't worth a penny, and you know exactly when the market will be faced with this unpleasant truth.
In these situations, selling stocks short is far less risky than buying even the safest blue-chip stocks. Selling short a "zero" leaves nothing to chance.
For instance, I'm convinced most of the major national homebuilders will go bankrupt this year. Long-time industry analysts have always known homebuilders never earn enough money selling homes to pay for the capital that's needed to buy and hold the land they require. Much like the airline industry, through its entire history, the homebuilding sector has been a consumer, not a producer, of capital.
A few homebuilders, like NVR, learned this lesson (after a bankruptcy in the early 1990s) and pioneered a new business model. NVR only buys finished lots that are ready to build on. It doesn't own real estate for development. And it only buys lots to provide land for existing sales efforts. As a result, NVR always carries fewer assets on its balance sheet and never needs debt financing to buy land. Yes, it pays a bit more for the land it needs, but it takes on a lot less risk. That's why NVR is still profitable today, despite all the carnage in the homebuilding sector.
At the other end of the spectrum are most of NVR's competitors. Out of fairness to my paid subscribers, I can't tell you which one is the surest to fail this year. But I can tell you that this homebuilder, like most of its competitors, bought a huge amount of land at inflated prices several years ago. It financed the purchases with debt. Since those purchases, the value of the land has collapsed, but the debt remains. That's a problem... but the company's real problem is that it's taking a big loss on every house it sells. It doesn't have any choice. It has to keep money coming in the door to keep the lights on and to pay its debts. It can't afford to wait until conditions improve.
This process of selling assets (at a loss) to pay interest and principal is a death spiral.
The firm can't make money selling houses and doesn't have enough assets to sell to pay all of its debts either. The more assets it sells, the closer it comes to violating terms it has with creditors. Violating these covenants would cause all of its debts to become due immediately – and force the company into bankruptcy. It's a lock to happen... which makes it an incredibly safe short-sale candidate.
My regular readers know I'm bullish on corporate bonds and the equity in the world's best businesses. Both are very cheap right now. But I'm also skeptical of highly leveraged, declining industries like commercial real estate and homebuilding. If you become familiar with these vulnerable business – and how to short them – you'll make the safest, surest profits of your life.
Good investing,
Porter Stansberry
