In investing parlance, to “short a stock” is to make an investment with the view that a stock’s price will decline. On the surface, shorting seems like a fairly easy thing to do for an investor who has skill in “going long”, which is to invest with the view that a stock’s price will rise – you just have to do the opposite of what’s working.
But if you peer beneath the hood, shorting can be a really difficult way to invest in the stock market. Nearly four years ago in April 2020, I wrote Why It’s So Difficult To Short Stocks, where I used the story of Luckin Coffee to illustrate just how gnarly shorting stocks can be:
In one of our gatherings in June 2019, a well-respected member and deeply accomplished investor in the club gave a presentation on Luckin Coffee (NASDAQ: LK)…
…At the time of my club mate’s presentation, Luckin’s share price was around US$20, roughly the same level from the close of its IPO in May 2019. He sold his Luckin shares in January 2020, around the time when Luckin’s share price peaked at US$50. Today, Luckin’s share price is around US$4. The coffee chain’s share price tanked by 76% from US$26 in one day on 2 April 2020 and continued falling before stock exchange operator NASDAQ ordered a trading halt for Luckin shares…
…The wheels came off the bus only on 2 April 2020. On that day, Luckin announced that the company’s board of directors is conducting an internal investigation. There are fraudulent transactions – occurring from the second quarter of 2019 to the fourth quarter of 2019 – that are believed to amount to RMB 2.2 billion (around US$300 million). For perspective, Luckin’s reported revenue for the 12 months ended 30 September 2019 was US$470 million, according to Ycharts. The exact extent of the fraudulent transactions has yet to be finalised.
Luckin also said that investors can no longer rely on its previous financial statements for the nine months ended 30 September 2019. The company’s chief operating officer, Liu Jian, was named as the primary culprit for the misconduct. He has been suspended from his role…
…it turns out that fraudulent transactions at Luckin could have happened as early as April 2019. From 1 April 2019 to 31 January 2020, Luckin’s share price actually increased by 59%. At one point, it was even up by nearly 150%.
If you had shorted Luckin’s shares back in April 2019, you would have faced a massive loss – more than what you had put in – even if you had been right on Luckin committing fraud. This shows how tough it is to short stocks. Not only must your analysis on the fundamentals of the business be right, but your timing must also be right because you could easily lose more than you have if you’re shorting.
Recent developments at a company named Herbalife (NYSE: HLF) present another similar illustration of the onerous task of shorting. High-profile investor Bill Ackman first disclosed that he was short Herbalife in December 2012. Back then, the company was a “global network marketing company that sells weight management, nutritional supplement, energy, sports & fitness products and personal care products” in 79 countries, according to its 2011 annual report. Today, Herbalife is a “global nutrition company that provides health and wellness products to consumers in 95 markets,” based on a description given in its 2023 annual report. So the company has been in pretty much the same line of business over this span of time.
Ackman’s short-thesis centred on his view that Herbalife was a company running an illegal pyramid scheme, and so the business model was simply not sustainable. When Ackman announced that he was short Herbalife’s shares, the company was reporting consistent and strong growth in its business. From 2006 to 2011, Herbalife’s revenue compounded at an annualised rate of 13% from US$1.9 billion to US$3.5 billion while its profit grew from US$143 million to US$415 million, representing a compounded annual growth rate of 24%.
Although Herbalife has to-date never officially been found to be operating an illegal pyramid scheme, its business results since Ackman came public with his short has been poor. The table below shows Herbalife’s revenue, net income, and net income margins from 2011 to 2023. What’s notable is the clear downward trend in both Herbalife’s net income and net income margin in that time frame.
Source: Tikr
According to a Bloomberg article published at the end of February 2018, Ackman had effectively ended his short position on Herbalife by the time the piece came to print. I think most investors who are made to guess Ackman’s returns from his Herbalife short by looking only at the trajectory of the company’s financials from 2011 to 2017 would have noted the stark deterioration – the company’s net income declined by nearly 40% and its net income margin shrank from 12.0% to 4.8% – and conclude that Ackman had probably made a decent gain.
But the stock market had other ideas. Herbalife’s stock price closed at US$23.16 on the day just prior to Ackman’s first public declaration of his short position. It closed at US$46.05 – a double from US$23.16 – when the aforementioned Bloomberg article was published. From December 2012 to today, the highest close for Herbalife’s stock price was US$61.47, which was reached on 4 February 2019. Right now, Herbalife’s stock price is at US$8.07. This comes after Herbalife’s stock price fell by 32% to US$8.03 on 15 February 2024 after the company reported its 2023 fourth-quarter results. Following the sharp decline, Ackman proclaimed on X (previously known as Twitter) that “it is a very good day for my psychological short on Herbalife.”
The market eventually reflected the deterioration in Herbalife’s fundamentals, but the interim journey was a wild ride. In a similar manner to Luckin’ Coffee (and borrowing the prose from the last paragraph of the excerpts above from Why It’s So Difficult To Short Stocks), if you had shorted Herbalife’s shares back in December 2012 and held onto the position till now, you would have faced a massive loss in the interim – more than what you had put in – even if you were right on Herbalife’s collapsing fundamentals and eventual stock price decline.
The investing sage Philip Fisher once wrote that “it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.” This explains why shorting stocks is hard – really hard. To be successful at shorting, you need to correctly read both the stock’s underlying business fundamentals and the timing of the stock’s price movement. In contrast, it’s far easier to recognise poor underlying business fundamentals in a stock and simply avoid investing in it.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.