1.Sloth: The first and biggest reason for failure in stock selection on either the short side or the long side is too little work. Particularly treacherous on the short side, the absence of a carefully reasoned case can have painful consequences. Usually, sloth is prompted by shorting someone else's idea. If, in moments of greed for new ideas, short sellers short stocks without the normal painstaking file-building, spreadsheet-accumulation, brain crunching work, the stocks will always go up quickly and scare the hell out of chastised sellers.
2. Pride/Hubris. Hubris is manifest in two primary analytic errors: (1) the sudden use of rigid formulas (2) the short sale of good companies. The first error is most common in situations where the short seller apply the same formula or spreadsheet or valuation methodology to a group of stocks without thinking because they have been successful in the past for this group of stocks. "This time is no different. " If they have seen 6 S&Ls go under with the same profile, it is easy to short the seventh without worry. The second hubris error is the good-company mistake. Most professionals have this one branded in fire someplace on their body; most amateurs do not realize that it is why they do not like short stocks anymore. Both Julian Robertson and Jim Chanos identified this phenomenon as the major short error. Shorting a good company is always risky. A good company is a company with smart management who pay attention to business trends and customers and who have financial statements reflecting that unlikely blend. If the stock is sold short simply because of valuation, the market immediately shows how high the earnings multiple can go. If a stock is shorted because of perceived temporary problems and because of excessive valuation, good management can fix the problems fast. Jim Chanos talked about shorting Fed Ex. He said Fed Ex was overvalued relative to earnings expectations. The company had temporary problems with Zapmail and new competitors that were causing operating margin problems. The company told him the problem was solvable but Jim Chanos did not believe them. When Fed Ex reported the quarter, it was a turn around, and the stock ran up 40%.
3. Timing: Underestimate the insanity of the public, especially during a bull market. Investor ebullience can keep a stock price up for years in spite of no earnings, even no product. The second reason for the timing problem is the ability of investment banks to sell another round of financing despite a seriously flawed corporate business plan. Continued flows of financing can keep a dead company on a respirator for years. In the same vein, some short sales fail because the seller underestimated the ability of a leveraged company to grow its way out of the problem-to grow top line faster than the debt capitalization. .
4. If a stock you are thinking of shorting is affected by commodity prices, track the underlying commodity price. If you are short a chicken stock, make sure you understand the chicken cycle, the impact of a drought or an ice store, and corn prices. It is easier to find fundamental balance sheet flaws than to trade grain prices, unless you work on the CBT. Sometimes, however, the presence of large inventory of a commodity on a balance sheet can be a clue that the company is either speculating rather than attending to business or has lost control inventories.
5. Be careful shorting technology stocks because normal trail signs do not usually apply.
6. Short a stock with small float.
7. Pigheadedness: If something changes, cover. It is not you against them: it is you against you.
8. Quotes from famous short sellers:
i. "The mistake is always shorting the company that's not that bad".
ii."The biggest mistake we've made are where we've seen a company that is overstating earnings but where the internal engine of the business is still strong.
iii. "You can hide disgusting accounting practices with growth for a very long time.