We run the risk of losing more than we can afford when we’re shorting stocks. So going short in the stock market can be far riskier than going long.

Shorting is the act of investing in stocks in a way that allows you to profit when stock prices fall. It is the opposite of going long, which is investing in a way that allows you to profit when stock prices rise. 

I’ve been investing for nearly a decade now and have done fairly well. But I’ve never shorted stocks. That’s because I recognise that shorting requires different skills from going long.

In the financial markets, I only want to do things that I’m sure I know well. In this article, I want to share two real-life examples on why it’s so difficult to short stocks.

My investment club

The first example starts with an informal investment club I belong to named Kairos Research. It was founded by Stanley Lim, Cheong Mun Hong, and Willie Keng.

They are also the founders of the excellent Asia-focused investment education website, Value Invest Asia. 

I’ve been a part of Kairos for many years and have benefited greatly.

I’ve made life-long friends and met countless thoughtful, kind, humble, and whip-smart people who have a deep passion for investing and knowledge.

Being in Kairos Research greatly accelerated my learning curve as both an investor and a human being.

To join the club and remain in it requires a membership “fee” of just one stock market investment idea per year.

It’s a price I’ve gladly paid for many years and I will continue to do so in the years ahead. 

Riding all the way up

In one of our gatherings in June 2019, a well-respected member and deeply accomplished investor in the club gave a presentation on Luckin Coffee (NASDAQ: LK). 

Luckin is a company that runs coffee stores in China. Its stores mainly cater for to-go orders and the company was expanding its store count at a blistering pace.

Within a year or so from its founding near the end of 2017, it already had more than 2,000 stores in China.

Luckin is considered a formidable competitor to US-based Starbucks in China; Starbucks counts the Middle Kingdom as its largest international growth market. 

At the time of my club mate’s presentation, Luckin’s share price was around US$20 (S$28), roughly the same level from the close of its IPO in May 2019.

He sold his Luckin shares in January 2020, around the time when Luckin’s share price peaked at US$50. Today, Luckin’s share price is around US$4.

The coffee chain’s share price tanked by 76 per cent from US$26 in one day on April 2, 2020 and continued falling before stock exchange operator NASDAQ ordered a trading halt for Luckin shares. 

Not the first time…

In January 2020, Muddy Waters Research said that it believes Luckin is a fraud. Muddy Waters Research is an investment research firm.

Luckin denied the accusations and its share price only had a relatively minor reaction.

There was a gradual slide that occurred in Luckin’s share price since then, but it happened with the backdrop of stock markets around the world falling because of fears related to the Covid-19 pandemic. 

The wheels came off the bus only on April 2, 2020. On that day, Luckin announced that the company’s board of directors is conducting an internal investigation.

There are fraudulent transactions – occurring from the second quarter of 2019 to the fourth quarter of 2019 – that is believed to amount to RMB 2.2 billion (around S$430 million).

For perspective, Luckin’s reported revenue for the 12 months ended 30 September 2019 was US$470 million, according to Ycharts.

The exact extent of the fraudulent transactions has yet to be finalised. 

Luckin also said that investors can no longer rely on its previous financial statements for the nine months ended 30 September 2019.

The company’s chief operating officer, Liu Jian, was named as the primary culprit for the misconduct. He has been suspended from his role. 

Given the announcement, there could potentially be other misdeeds happening at Luckin.

After all, Warren Buffett once said that “What you find is there’s never just one cockroach in the kitchen when you start looking around.”

It’s tough being short

Here’s a chart showing Luckin’s share price from its listing to April 2, 2020:

The first serious allegations of Luckin committing fraud appeared only in January 2020, thanks to Muddy Waters Research. But it turns out that fraudulent transactions at Luckin could have happened as early as April 2019.

From April 1, 2019 to January 31, 2020, Luckin’s share price actually increased by 59 per cent. At one point, it was even up by nearly 150 per cent.

If you had shorted Luckin’s shares back in April 2019, you would have faced a massive loss – more than what you had put in – even if you had been right on Luckin committing fraud.

This shows how tough it is to short stocks.

Not only must your analysis on the fundamentals of the business be right, but your timing must also be right because you could easily lose more than you have if you’re shorting. 

Going long though is much less worrisome. If you’re not using leverage, poor timing is not an issue because you can easily ride out any short-term decline.

Even the legend fails

The other example I want to highlight in this article is one of the most fascinating pieces of information on shorting stocks that I’ve ever come across.

It involves Jim Chanos, who has a stellar reputation as a short seller. A September 2018 article from finance publication Institutional Investor mentioned this about Chanos:

“Chanos, of course, is already a legend. He will go down in Wall Street history for predicting the demise of Enron Corp., whose collapse resulted in a wave of prosecutions and the imprisonment of top executives — the kind of harsh penalties that have not been seen since.”

The same Institutional Investor article also had the following paragraphs (emphasis is mine): 

“The secret to Chanos’s longevity as a short-seller is Kynikos’s flagship fund, the vehicle where Kynikos partners invest, which was launched alongside Ursus in 1985. Kynikos Capital Partners is 190 per cent long and 90 per cent short, making it net long. Unlike most long/short hedge funds, however, the longs are primarily passive, using such instruments as exchange-traded funds, as the intellectual effort goes into the short side.

Chanos argues that by protecting the downside with his shorts, an investor can actually double his risk — and over time that has proved a winning strategy. Through the end of 2017, Kynikos Capital Partners has a net annualized gain of 28.6 per cent since launch in October 1985, more than double the S&P 500. That has happened even though the short book — as represented by Ursus — has lost 0.7 per cent annually during the same time frame, according to a recent Kynikos document Institutional Investor has obtained.”

It turns out that Chanos’s main fund that shorts stocks – Ursus – had lost 0.7 per cent annually from October 1985 to end-2017!

That’s Jim Chanos, a legendary short-seller, losing money shorting stocks over a 32-year period! 

My conclusion  

Stocks with weak balance sheets, inability to generate free cash flow, and businesses in rapidly declining industries are likely to falter over the long run.

But it’s far easier to identify such stocks and simply avoid them than it is to short them. 

Besides, the math doesn’t work in my favour. The most I can make going short is 100 per cent while my potential loss is unlimited.

On the flip side, the gain I can earn going long is theoretically unlimited, while my potential loss is capped at what I’ve invested.

When we go short, we run the risk of losing more than we can afford – that’s true even for fraud cases. As a result, I’ve always invested with the mentality that going short in the stock market is far riskier than going long.

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This article was first published in The Good Investors.