Short Selling

Amit Kumar is a portfolio manager at Columbia Threadneedle investments and has spent over a decade in equity investments. Amit holds an MBA in Finance from Columbia Business School and is a Chartered Financial Analyst. He specialises in the discretionary consumer and technology sectors.


Shorting stocks is dangerous. This is because one can lose more than one’s exposure to the stock. For example, if we sold 1,000 shares of a company at 100p giving us £1,000 of exposure, we would have to pay £2,500 back if the company’s stock rose to 250p. In theory, when shorting losses are unlimited. Squeezes can occur when there are rushes to buy the stock to cover too meaning large positions can be caught offside.  The book is a complete text in the fundamentals and market mechanics of shorting. Shorting is a controversial strategy but serves its market purpose of keeping rampant bulls in check from distorting valuations too far from reality.

Key themes

Expensive stocks

The market is inherently bullish and so what is an overpriced stock can easily become more overpriced as investors fall over themselves to buy. Shorting expensive stocks based on valuation only is dangerous and researching short ideas requires the same fundamental skills as for long positions. The other reason shorting stocks is dangerous is because very often those stocks that appear expensive can, in hindsight, appear cheap, as growth continues and margins increase. Greed often takes longer to peak than fear. A good example of this is Blue Prism [EPIC: PRSM], which had a meteoric rise that seemed way out of tune with its fundamentals.

Value traps and broken growth

When shorting, look for value traps and broken growth stories. A value trap is a stock that appears cheap but is actually expensive, for example a company with a single digit PE may get cheaper because the profits are falling but the share price is falling faster! Broken growth stories can be profitable as the market still prices the company as a growth company and the PE has yet to deflate. Broken growth stories can often be affected by disruptive technologies as a competitor comes and undercuts them.


Leveraged businesses can also be profitable shorting opportunities. Creditors are ahead of shareholders to get repaid in an event of bankruptcy. Financial leverage increases with borrowings and a company unable to pay this or breach covenants can suffer distress.

Operational leverage can be a double edged sword. Fixed costs can gear profits but they can also be a problem when profits are falling. Retailers who are locked into fixed length leases enjoyed this when the going was good, but declining footfall and an inability to exit has caused several CVAs this year already. Leverage can also be hidden in commitments and contingent liabilities.

Financials and cash

An increase in trade payables and receivables not being collected can be cause for concern. This is because cash may need to leave the business and cash is not coming into the business, causing a shortage of working capital. An example of this would be channel stuffing, where a business sells to a retailer, books the profit, yet does not collect the cash until the product is sold. If the product is not sold then the cash is not collected but the profit is booked! Companies that aggressively book profits before collecting cash can run into trouble in the future. In 2012, Incyte decided to recognise its revenues when the pharmacy received their product (sell-in) instead of when then the pharmacy sent the product to the patient (sell-through).

Goodwill on the balance sheets appears after acquisitions and whilst some call this overpaying, a business will never be able to buy a profitable business at book value of the parts. It is always worth checking a balance sheet to see if there are any capitalised costs or goodwill making up a large part of the assets.


It it is necessary to identify a clear catalyst when shorting. These can be profits falling, loss of market share, structural issues, poorly incentivised management, issues with share structures, and also high debt levels. Economic downturns affect some industries more than others, for example the financial crisis forced many banks and airlines out of business. It is worth checking the metrics drive management compensation – EBITDA is obviously subject to management’s discretion and there would be an incentive to be lax with depreciation and amortisation in order to inflate short term earnings.


One of the big risks of shorting shares is a takeover, as a competitor views the company on the cheap and is prepared to pay a small premium in order to get the best bits of the company and dispose of the rest. It is always best to be careful when shorting small and micro caps – I have heard a story of one unlucky investor short on a share, the stock received a takeover offer and suspended, and the investor was held to ransom by his brokerage when he tried to cover the trade.

Another risk is valuation risk. Shareholder equity is what is left over from taking away liabilities from the assets, but if one makes a mistake on the asset valuation this can severely impact the equity position. For example, if a company has assets you believe are worth £10 million, and the liabilities are worth £7 million, this means shareholder equity is £3 million. But if the assets are only worth £9 million, this means equity is £2 million! A 10% reduction is asset value has led to a 33% reduction in the shareholder equity.

Leave a Comment

Your email address will not be published. Required fields are marked *

Scroll to Top

Almost there!

Enter your email below to receive my four free stock trading ebooks with everything you need to start trading the UK stocks.


Get your free stock trading ebooks

Get four free UK stock market ebooks and my monthly trading newsletter with trade ideas and things learned from trading stocks


Don't miss out!

Get four free UK stock market ebooks and my monthly trading newsletter with trade ideas and things learned from trading stocks