When investors short-sell a particular stock, they are betting its stock price will drop. This allows them to buy back the shares they are short at a lower price and pocket the difference. Short-selling can be incredibly rewarding if you're on the right side of the bet. However, if said stock goes up, short-sellers must cover their positions by buying back the stock at a higher price, incurring a significant loss in the process.
To help you navigate the risky strategy of short-selling, three Motley Fool contributors explain below why they would never short shares of Tesla Motors (NASDAQ: TSLA ) , Amazon (NASDAQ: AMZN ) , or Netflix (NASDAQ: NFLX ) , and why you shouldn't either.
Tamara Walsh (Tesla Motors): More than 23% of Tesla's outstanding shares are currently sold short. While that means a lot of people are betting against the company, it could also benefit investors who are not short the stock. Let me explain. When many short-sellers cover their positions in a stock at the same time, it leads to a short squeeze, or a surge in the stock's price -- thereby crushing shorts in the wake.
Tesla's stock has experienced more than a few short squeezes over the past two years, and it's only a matter of time until we see this happen again, given the high short interest in the stock today. This, coupled with the visionary leadership of Tesla's CEO, Elon Musk, are two reasons I would never short the electric-car maker. Musk was quick to tease short-sellers last year on Twitter, writing, "seems to be some stormy weather over in Shortville these days."
His jokes about the naysayers are more than justified. Tesla Motors, after all, has gone from being the fourth most-shorted stock on the Nasdaq three years ago to one of the top performing stocks today. There are also a lot of reasons to be optimistic about Tesla's future.
The California-based automaker is aggressively growing its footprint in overseas markets such as China, it is rolling out new high-margin options, including its dual electric motor Model S car, and deliveries of its much anticipated Model X crossover EV will hit the road in early 2015. The takeaway here, folks, is that Tesla Motors is not a stock you want to risk shorting.
Joe Tenebruso (Amazon.com): The primary danger of shorting a stock is that while you can make 100% if the company you short goes bankrupt, your downside risk is theoretically unlimited. Therefore, one type of stock I would never short is what I call an open-ended growth story. E-commerce titan Amazon.com is the epitome of the type of staggering and unending growth I'm referring to.
To attempt to short such a stock can be analogous to stepping in front of a bus... followed by a steamroller... followed by a tank. Many short-sellers have been absolutely crushed by Amazon's incredible ascent -- and unfortunately for them -- many more likely will be in the years ahead.
That's because while it's true that Amazon's stock price has pulled back sharply from the all-time highs it reached in January 2014, I believe the downturn will be short-lived. Incredibly, even after the stock has risen more than 100 times in value from its 1997 IPO, the potential still exists for more multi-bagger returns from this point forward. Amazon is tremendously well-positioned to benefit from the booming growth of Internet-based commerce, which still accounts for less than 10% of total retail sales. Yet that figure is growing rapidly, and it's a fast-rising tide that's propelling Amazon's sales along with it.
Bears will point out that even with Amazon's impressive revenue generation, it's failed to produce much in what they'll argue is far more important: profits. This too is true, although a look at cash flow generation will paint a far brighter picture.
But what short-sellers should be most concerned about is that, in many ways, shorting Amazon is a bet against the growth of the Internet. It's also a bet against convenience and innovation. And it's a bet against tried and true principles of economics such as the benefits of economies of scale and the power of a wide, competitive moat that grows stronger by the day.
That's not a bet I'm willing to make. Are you?
Bob Ciura (Netflix): Netflix is a stock I would never short. Not necessarily because the stock price can't go down; indeed, stock prices rise or fall on a daily basis. But rather, Netflix is on a strong growth trajectory, and any dips in Netflix's stock price over the past few years have proven to be short-lived bumps in the road on a longer trend higher.
Investors may recall that in October, shares of Netflix crashed 20% after reporting quarterly earnings. In hindsight, it's easy to see Netflix's lofty valuation as the sure reason for the sell-off. The problem with this is that by most traditional metrics, Netflix has always been over-valued, and the stock has continued to rally over the past few years in spite of that. For example, Netflix earned $0.29 per share in 2012. Even at its lowest stock price that year, roughly $55 per share, the stock still traded for 180 times that year's EPS. Based on valuation alone, you'd think Netflix would have been a great short heading into 2013. But shorting Netflix would have been a disastrous move: The stock soared almost nine-fold that year.
The point is that growth stocks don't typically trade on valuation, they trade on growth prospects. The reason Netflix sold off after earnings last quarter was that costs in Netflix's international business rose faster than expected. The sell-off post-earnings had little to do with valuation, just as Netflix's performance in 2013 had little to do with valuation. But it should come as no surprise that Netflix is plowing into new markets, because domestic growth is slowing. Netflix shocked investors by announcing that it expects to lose $95 million this quarter in its international streaming business because of the heavy investment costs being made. But its fourth-quarter guidance still calls for 35% revenue growth in its combined streaming businesses, and Netflix expects to add another 4 million members this quarter thanks to its investments. Netflix's higher-than-expected costs are now no longer a surprise, and these investments will pave the way for strong growth next year.
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