For Short Sellers, Wall Street’s Bad News Is Good News

Try this quiz: Virtually every stock market index is cresting near a record high, so why is there also a record number of short interest positions by investors who expect certain stocks to crash?

One answer: Both bulls and bears are chronic optimists.

“I have never seen a more attractive time for short selling than this spring,” says William Fleckenstein, a Seattle money manager who runs a $15-million short-sellers fund and claims to have done better last year than the 34% jump in the Dow Jones industrial average.

Short sellers, like Fleckenstein, borrow shares of stock, sell them and promise to replace them later. The shares of a company’s stock that must be repurchased to cover that debt is called short interest. Because short sellers make money by buying back the stock at a cheaper price, they occupy a vulture-like role in Wall Street’s food chain. “It’s easier to hate short sellers,” Fleckenstein says.

By his reckoning, the U.S. stock market has been on such a long, uninterrupted run that any value-priced issues are long gone, replaced by many stocks that are “overvalued by 500%.” He’s got 15 stocks shorted now, including big technology firms such as Advanced Micro Devices and Micron Technology, and he foresees gloomier--and for him, better--days as interest rates jump, baby boomers stop pouring money into mutual funds and, according to this iron law of ballooning, stock prices fall back to Earth.

Richard Herzer, chief executive at IHOP Corp., has felt five years of fear and loathing as short sellers dogged his Glendale-based pancake restaurant chain. “I’m not happy they are betting against me. That’s just my ego,” he said.

Back in 1991, investors shorted about 1.2 million shares of IHOP during its $10-a-share initial public stock offering. Short sellers figured IHOP’s profit would slow because the company couldn’t keep finding new sites fast enough to sell to franchisees. The result: IHOP carried one of the biggest short-interest ratios on Nasdaq.

“They took a position early on without digging into the facts about what makes this company run,” Herzer said. IHOP’s profits kept rising, and so did its stock--it trades now at around $29 a share--but for years IHOP was looking at 1 million-plus shares of short interest, and Herzer didn’t like it.

Short sellers must pay dividends--to whomever they borrow shares from--to match any dividends paid out by the companies. IHOP doesn’t pay cash dividends to shareholders, but Herzer was so peeved by short sellers that he talked to his board of directors about paying a dividend just to drive the short sellers out.

“Yeah, we talked about it. But we decided the hell with them,” Herzer remembers. Prudence won out. “We decided all we have to do is sell more pancakes,” he says. That strategy is working. IHOP’s short interest is down to about 400,000 shares, he reports.

IHOP is winning its battle against short sellers, but several other local companies remain big targets.

* House of Fabrics, the Sherman Oaks retailer that has been mired in bankruptcy court since 1994 and hopes to climb out in July, has 971,700 shares of short interest. Given a typical day’s trading volume, it would take 21 days for short sellers to cover their House of Fabrics position--anything over 10 days is considered notable. Along the way, short sellers who took aim early have made money, since House of Fabrics’ stock now trades around 75 cents a share, down from $14 in 1993.

* Datametrics, a long-struggling Chatsworth computer-printer concern, saw its short interest jump 36% in May, with 11 average trading days needed for short sellers to cover their positions.

* Incomnet, a Woodland Hills-based long-distance phone company that has been burdened with turmoil in its executive suite, has 1.3 million shares of short interest, or 19 trading days worth.

Another company that’s felt heat from short sellers is Xircom, a Thousand Oaks maker of components for mobile computing. A couple of years ago, Xircom was a widely touted stock and jumped to $28 a share. Then rivals made inroads into Xircom’s territory. Short sellers swarmed in like sharks and tough times followed.

It’s easy to “become resentful of short sellers. But you’re not going to prevent the shorts from working your stock, particularly when there are clouds” around the company’s prospects, said Jerry Ulrich, Xircom’s chief financial officer.

For a while, Ulrich was busy quelling rumors--spread, he believes, by short sellers--as stock analysts called to find out if Xircom’s founder was resigning, if the company was filing bankruptcy, etc., etc.

“These rumors were patently untrue,” he says. Xircom managed its troubles well, so “the stock eased its way down, as opposed to a 50% drop in one day,” Ulrich says. “That’s where the shorts can really make money.”

As Xircom recast its marketing and trimmed some jobs, its sales picked up again. Six months ago, Ulrich was delighted to read that a stock newsletter was closing out its short position on Xircom. Since then, Xircom’s short interest has steadily declined. “It’s good news when you’ve squeezed the shorts out,” he says.

But as Xircom’s stock sank to $9 a share--it’s now back to around $16--Ulrich also concedes that short sellers “made some money.”

One reason for soaring short interest is that investors can also short stocks with options, futures, derivatives and various other byzantine instruments. There has also been a surge in hedge funds, so-called because their managers also short stocks to mix with their upbeat picks as a way of balancing their portfolio. The number of hedge funds in the United States is climbing 20% a year and now stand at 3,600, according to Van Hedge Fund Advisors in Nashville.

Even those who make a living by recommending stocks to buy track what short sellers do. Jim McCamant, editor of the Medical Technology Stock Letter in Berkeley, which follows biotechnology, says: “On occasion shorts do pick up something before it is commonly known, and it can be reflected in a short-interest position.” McCamant believes in survival of the fittest, and given the long run-up in stock prices, the few short sellers left, he figures, are quite skilled.

So McCamant tracks short interest in biotechnology stocks, including Amgen, the Thousand Oaks giant. Amgen’s $16-billion market capitalization--the value of all its stock--represents almost one-third the value of all biotech stocks. So he uses the shifts in Amgen’s short interest as an industry barometer. “It tells me something about what people’s attitudes are” toward biotechnology.

In one sense, short sellers have to be better than conventional stock pickers, because they take greater risk. Why? If you buy a $20 stock, the most you can lose is $20 a share. Someone who shorts that $20 stock faces an infinite loss, if the stock price keeps running up. Indeed, sometimes short sellers contribute to the wild, volatile jumps in prices when they rush to buy back shares to cover their position and prevent bigger losses.

Fleckenstein says this means that shorting stocks is “absolutely, without question” more nerve-wracking than conventional investing.

So why do it?

“Bears are optimists. We hope to be right too.”