Short-Selling with the O'Neil Disciples. Morales Gil

started, it might be worthwhile to discuss how we DO NOT sell stocks short.

      Often times we hear of a prominent hedge fund manager who goes on financial cable TV and declares a certain high-flying stock to be the beneficiary of nothing more than irrational, speculative fever on the part of mindless, lemming-like investors. Generally this hedge fund manager is a graduate of what we like to refer to as the University of “I-Am-Smarter-than-the-Market.” As such, he or she is one who is “smarter” than the mass of investors who get carried away with the “hype” surrounding a given “hot stock” and thereby sees fit to declare that the fundamentals of the company in question “do not justify” its often-high and going-higher stock price.

      High-flying stocks that have attracted more than their fair share of naysayers who consider the stocks' ever-rising prices as representative of a sort of moral infirmity among investors have in recent years included great companies like Netflix (NFLX), Tesla Motors (TSLA), and 3D Systems (DDD), for example. Getting up on financial cable TV and declaring investors in such stocks to be misguided doesn't win one a lot of fans, and because most of these hedge fund managers try to short these stocks on the way up, they generally end up looking stupid before they start looking smart, as the basic axiom of investing, essentially that the trend is your friend, often persists, even when it comes to allegedly overvalued stocks. Trying to short a stock based on the fact that it is overvalued ignores basic stock market reality when it comes to P/E ratios in leading stocks and seems to stand in the way of the dominant upside technical trend. Countless numbers of high-flying stocks over the years have been downgraded by analysts on the basis of being overvalued. This was especially true in the late 1990s with so many dot.com stocks reaching dizzying heights in price despite being downgraded a number of times by analysts.

Netflix (NFLX) is a more recent example of such a phenomenon, as it endured the wrath of a couple of very vocal “valuation” short-sellers all the way up during the incredible price run it had from early 2009 to mid-2011. Valuation short-sellers are those who believe a stock's price is going to go down because its price-to-earnings ratio, or P/E, is far too high. In December of 2010, a hedge fund manager we will simply refer to as “W” wrote an article in a prominent investment blog discussing the reasons why he was selling NFLX short. The day that article appeared, NFLX closed at a price of $181.65 a share. Within seven months the stock price hit an all-time high of $304.79, not too long after “W” had revealed that his fund had covered its short-sale position, unable to withstand the pain of the losses its NFLX short position generated as the stock ground its way higher, as can be seen in Figure 1.7.

Figure 1.7 Netflix (NFLX) weekly chart, 2009–2011. There was a time to be long NFLX and a time to be short NFLX. Self-proclaimed graduates of the University of “I-Am-Smarter-than-the-Market” had trouble identifying either.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

      W's primary reason, his only reason in fact, for shorting NFLX was that its P/E was “too high” and that the company's business model could not possibly generate the revenues and profits such a valuation implies. This, of course, ignores the fact that a P/E ratio is less a measure of static value and more a measure of the marketplace's current assessment of a company's forward earnings stream. If one objectively studies the price/volume action of leading stocks that have huge price moves, one quickly realizes that during these massive upside price runs the P/Es of these stocks actually expand, often to 100 or more times the current earnings. Price strength often begets further price strength, thus stocks and even markets themselves often go far higher than most analysts expect.

      Individuals like these are seen as “negative nellies” who fail to understand the dynamic nature of the U.S. stock market and the essential direction of money flows into and out of leading stocks during their life cycles. It's one thing to walk into a clothing store and declare a pair of jeans with holes in the knees to be grossly defective and hence not worth the price tag; it's quite another to recognize the contextual fact that sometimes jeans with holes in them represent the hottest, cutting-edge fashion statement that every style-minded consumer must make at any price. And so it is with stocks.

      In our view, these valuation short-sellers give short-selling a bad name. They want to think negatively about a situation that is being viewed positively by investors who see the stock market as a realm of opportunity and possibilities. As well, valuation short-sellers ignore the psychological nature of the markets, and the inherently dynamic potential, often unknowable in precise terms before the fact, of an emerging-industry business model that can only be sorted out in advance by the “mass mind” of the stock market, e.g., millions of investors making real-time decisions with real money based on their best real-time knowledge and forward assessments.

      To illustrate this idea, take the example of Apple (AAPL) in 2004 after it had come out with the iPod, ostensibly, as some argued at the time, an mp3 player “in drag” and nothing more. But the iPod product, fathered along by the genius of one Steve Jobs, would provide the platform for even more massive-selling products like the iPhone, which truly revolutionized the smartphone, and the iPad, which turned the PC on its head, over the next several years. The point is that stock market opportunities are dynamic and evolve as more and more investors begin to see the potential of a company's product platform and its role within a potentially huge emerging market for those products. Such was the case with Apple.

      Eventually, however, there came a time to sell Apple short, but only when the stock's strong uptrend had finally reversed itself as everybody who was going to be in the stock eventually was. This left only one direction for money flows in the stock to begin moving, and that was out. “Pile in, pile out” was a critical phenomenon that was readily observed in the institutional fund ownership data for Apple as it finally topped and rolled over.

Another entirely underestimated company and investment opportunity that serves as an added example is the highly innovative electric car maker Tesla Motors (TSLA), shown on a weekly chart in Figure 1.8. In May of 2012, we notified our subscribers of a “buyable gap-up” in the stock in the mid-60 price range at what was roughly the start of a robust upside price run that eventually carried above 290 by the summer of 2014. At the time we also saw Tesla Motors as being similar to General Motors (GM) in 1915 when the stock of that future “big three” U.S. automaker began its own significant post-IPO price move. In the same manner that Tesla was bringing style and power to the otherwise mundane and utilitarian-oriented electric vehicle market in 2013, General Motors had introduced a mass-produced V-8 combustion engine that enabled the fledgling auto concern to bring style and power to the mainstream and help to accelerate the popularization of the automobile. Like Tesla in 2013, General Motors in 1915 was a recent IPO, having come public in 1911. Also like Tesla in 2013, General Motors in 1915 had been moving in a big, sideways consolidation for about 2.5 years before breaking out and initiating a massive upside price move. Thus we saw a historical “precedent” for what was going on with Tesla Motors based on the theme of a new company pushing the envelope of an emerging industry, in this case electric vehicles in 2013 as compared to what General Motors was doing with the combustion engine as it was pushing the envelope of the auto industry in 1915.

Figure 1.8 Tesla Motors (TSLA) weekly chart, 2012–2014. The emotional rants of the “Tesla bears” only seemed to propel the stock higher as short interest in the stock remained high all the way up through the $200 price level.

      Source: Chart courtesy of HGSI Investment Software, LLC (www.highgrowthstock.com), ©2014.

      Despite the fact that Tesla was selling at 100 times forward earnings estimates at the time, it was still able to generate a huge upside price move that began at the point where we first bought the stock, essentially in the mid-60 price area, in early May of 2013. Considering that it is not uncommon for such a “ridiculously