Sweep has some good points which I mostly agree with.
Highly valued stocks are highly valued for a reason – people want to own them and are willing to pay a lot (over pay). To bet against them, you need to figure out what would cause people to not want to own that stock anymore and then time your short appropriately. Simply shorting expensive stocks is a good way to hit a margin call because the trend usually persists in one direction until there is a sharp correction, and that trend may be anywhere from somewhat to a lot disconnected from fundamentals.
The Street’s game is discounting next quarter’s and next year’s earnings, but the Street as a whole is pretty bad at understanding business models and structural changes in those models or industries that will impact future results. I find it difficult to beat the Street at its own game (my estimate was more accurate by a penny), so I focus on large shifts that will have undeniably negative impacts on the business model, thereby negating one specific quarter’s worth of earnings. You can also short on tough comps with generally slowing momentum.
A few examples:
BEAT – management was lying about business prospects in front of aggressive 3 year guidance numbers. Who guides out that far for a start up business? They got killed by reimbursement. Stock went from $30 to 3.
AMSC – management was lying and committing accounting fraud. After a legacy contract expired, the stock dropped from the low 30s to 3 or less (I closed at 3).
HEV – management lying with unsustainable business model, stock went from 6 to zero.
SODA – tough comps with a fad product (home soda machines? who are you people?)
HOKU – broken business model with dishonest management. Stock went from 6 to zero (such a lay up). Was much higher than that but I didn’t find it in time.
Several others, etc.
I am actually better at going short than going long even though in theory shorting is harder. One of the keys to going short is finding the lie – for it to be overpriced, people have to believe in some “story” that is untrue. If you start with the “claim” and then deconstruct that, you can sometimes figure out that what they are saying is impossible. Usually the numbers will sound very compelling but the overall pitch doesn’t really make sense (HEV – electric batteries made in the US backed by government funding for a product already being made by scale players in Asia for a market that doesn’t really exist yet – how does that even make sense?). After that it is just a question of timing.
The part I disagree with Sweep on is that I think shorting is very worthwhile. In the context of a total portfolio, a well developed short portion of the book provides an incremental source of alpha while providing overall insurance to the portfolio in a sense (in the event of a major market decline). The reason long / short funds make sense is because you reduce overall exposure and increase performance, assuming you can identify good picks on both sides. Obviously, that’s easier said than done, but if you look at a lot of stocks, some will jump out as shorts – if you wouldn’t even think about looking twice as a long, how is it not at least a decent short candidate worthy of research?