Usually, there are just three types of stocks that I will short:
- Stocks that are insanely overvalued. I tread carefully with these because they are often subject to strong momentum by traders, and even a stop-loss can be blown through. A good example is when I shorted Netflix (NASDAQ:NFLX) in the high 200s.
- Stocks in what have become “sunset industries.” I’ve written about newspapers as one such short. These will take awhile to develop and pay off, but they will. In fact, stay tuned, because another industry just got the “nail-in-the-coffin” signal and I’ll write about that soon.
- Stocks that are clearly headed for bankruptcy. (And I’ll give you examples in a moment.)
But what happens when your broker can’t find shares to borrow of the stock you wish to short? Worse, what if there are shares to borrow but there’s an unreasonable vig attached — that is, an interest rate charged by the person lending the shares for you to short? Your only option is to use puts. It’s trickier, because you have to decide on a target and a time frame, but it’s possible. Here are three examples where you can use this strategy:
Groupon (NASDAQ:GRPN) has cratered since its IPO. It was at $26, now it’s at four bucks and change.
I was skeptical about this IPO from the start because Groupon violates two important investing precepts: First, it doesn’t solve a problem. All it does is offer discounts. Yes, those discounts are huge, but that’s not a fundamental problem that needs to be solved. Second, there’s nothing unique about it. It has direct, focused competitors like LivingSocial, and Google (NASDAQ:GOOG) and Amazon (NASDAQ:AMZN) have gotten into the game.
I think Groupon will go under, but I can’t short the stock. In this case, you don’t want to pay a premium when the stock is so close to zero. So buy a deep-in-the-money put that eliminates the extrinsic value of the option. You are now effectively tied to the stock price.
Buy the January 2014 $25 put for $21. You are effectively short the stock, and still able to exit by selling it for either a profit or loss anytime between now and expiration.
Yelp sort of solves a problem — getting reliable reviews on restaurants and other places by crowdsourcing that data. It’s a community with a pretty good track record. It has a degree of brand value, but not so much that a competitor couldn’t easily take it down. Remember MySpace in the days before Facebook (NASDAQ:FB)? Still, I’m not calling for its death.
But on a valuation basis, YELP presently trades at infinity times its net loss, and at 154 times next year’s estimates. But I can’t find shares to short this crazy valuation! The best I can do is buy a February 2013 $35 put for $14. I’d like to go further out and deeper in the money, but my broker doesn’t have those options right now. Still, given Yelp’s volatility and overvaluation, all it takes is a bump and it’ll be below $21.
Education Management Corporation
Education Management Corporation (NASDAQ:EDMC) is being sued by the government for $11 billion, which is a tad bit more than the $571 million in cash it has on hand. Even if EDMC settles, it’ll eat into that cash hoard. This comes on top of weaker-than-expected performance.
The company sits at $3.11 per share at this writing, with no shares available to borrow at my broker. Buy the March $7.50 puts at $4.55.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.