The Key to Short Selling

Beginning with this issue of HX Daily, we will tackle trading and investing concepts every Thursday. We will do a deep dive into a concept or metric to help you understand how to become a better trader or investor.

Today, we are going to talk about the key to short selling.

Some investors have negative views of short sellers and short selling. We agree that sometimes short sellers act improperly, but overall, they serve a vital role in the stock market.

They help uncover dangerous situations in which investors—retail or institutional—may be deceived, and they end up saving folks a lot of money.

These “fraud” type of shorts, though, are only a small percentage of stocks that go down.

Remember, the goal of short selling is not to uncover and disclose a company's nefarious action but rather to profit from the stock's falling share price.

The internet barely began when we began our careers in the 1990s. There was no such thing as a “PDF,” and we still read many research reports in physical form.

There were many more "fraud" shorts back then because the dissemination of information was much more limited.

The world is MUCH different today.

Listen to our recent podcast with value investor and activist short seller Gabriel Grego, and you can hear more on this topic. You can listen to it here or watch it here.

As a result of these changes in market structure, many investors have argued that short selling is dead. We have heard this said a lot.

It is also one of the dumbest statements out there.

As we said above, short selling aims to find stocks that go DOWN. It is NOT to uncover frauds or prove yourself right.

Saying short selling is dead is the same as saying stocks will never go down again.

We know that there will ALWAYS be stocks that go down. The key to short selling is finding these stocks.

This brings us to one of our core views on investing: Look for earnings growth and revisions to understand the path of stock prices.

Now, "growth" doesn't just mean positive growth but can also mean declines.

If you can find stocks with earnings going down – on an absolute basis and analyst revisions – then you will find some good (or great) shorts.

We thought of this recently when we were listening to CNBC, and they talked about discount retailer Five Below, Inc. (NASDAQ: FIVE).

This stock has been an awesome winner in the last few years but has recently been hit hard. Here is the chart of the stock price over the last five years…

You can see that from the summer of 2022 through the middle of last year, the stock had a nice run, trading from $115 a share to more than $200 per share. It was around those levels even just a few months ago.

Then the stock cratered! What happened?

Look at this chart of earnings revisions…

A couple of years ago, the company was expected to earn almost $9 per share in this fiscal year. However, that number is now below $5 per share.

The precipitous drop in the stock coincides strongly with the slide in earnings revisions. THIS is why the stock is going down.

Now you could look at this chart and ask – why didn’t the stock go down when the earnings revisions were coming down back in 2022 and early 2023?

There are several answers to that question. In 2022, there was a perception that they were working off the post-COVID hangover of binge buying. Then, in 2023, the revisions were negative but not THAT bad.

One thing is for sure, though a SMART long investor would not have wanted to own this stock.

Why own a stock with negative earnings revisions when so many have positive revisions?

A savvy short seller also would have become interested. The stock rallied and then trod water as earnings estimates ground lower. THIS was a nice risk/reward as a short seller and precisely the kind of stock you want to be looking to identify.

Short selling is not dead, but you must know what to look for in a successful short.

Find a company with negative earnings revisions, and you will have a good start!

HX Podcast

This week Enrique is joined by one of our readers and they discuss the outlook for the stock market in the near term and through year-end.  Enrique also gives an update on the HX FREE IDEA.

Check out our timely commentary to help YOU make money!

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The HX Podcast with Enrique Abeyta brings you up-to-date financial market commentary along with evergreen insights into investing, trading and building your financial future. Enrique has 30+ years experience as a professional investor having managed billions of dollar in his firms. He brings on other world class investors and special guests to discuss investing and trading in a humorous and approachable manner.