BOSTON Stocks targeted by short sellers plummeted last year. The 10 most shorted stocks heading into 2011 dropped an average of 31 percent over the next 12 months. Some, like retailer Sears Holdings Corp, for-profit college company Corinthian Colleges Inc and technology equipment maker Veeco Instruments Inc., lost closer to 60 percent.
So funds that specialize in shorting - selling borrowed shares and betting they will drop so they can be bought back at a lower price - must have made a killing, you might think.
Well, not so fast. These bear market funds lost 9.52 percent on average in 2011, according to fund researcher Lipper, a unit of Thomson Reuters.
What happened? Much of the problem likely comes down to bad timing -- a problem that often bedevils short sellers. Because they can lose many times their initial investment as a stock rises, short-oriented fund managers sometimes just can't afford to stick with their bets if prices rise too far, too fast - even if they remain absolutely convinced the stocks will eventually crash.
And in last year's highly volatile market, driven by sentiment that quickly swung from panic to exuberance and back, some heavily shorted stocks such as movie rental company Netflix Inc and Green Mountain Coffee Roasters Inc soared to new highs before taking a tumble.
"It's true there were some big name blow ups last year," said Greg Swenson, co-manager of the Grizzly Short Fund. "But for a lot of people it may have been more frustrating than anything else. After you've taken a beating for so long, you're usually not in position for as big a win."
Swenson's fund, overseen by Leuthold Weeden Capital Management in Minneapolis, Minnesota, beat the category average, dropping only 1.92 percent in 2011. That is better than other short funds such as the Federated Prudent Bear Fund, which lost 7.61 percent, but still behind the 2.11 percent gain for the S&P 500 including dividends.
Fund manager Whitney Tilson of T2 Partners famously threw in the towel on his short of Netflix in February as the stock soared past $200 a share on its way to $300. Netflix peaked at $304.79 in July before tumbling to $62.37 in November - an almost 80 percent loss -- after a series of bungled price hikes and service changes.
"Even in 2010, there were all kinds of threats to their business model," said Albert Meyer, a money manager at Bastiat Capital in Plano, Texas. "But then they shot up to $300. It's very, very difficult to stay short for that. And short sellers tend to quickly cover."
The same went for other popular shorts such as First Solar, up almost 35 percent in January and February to a peak of $175.45 before crashing to a low of $28.79 in December as the prices of the solar panels it makes fell dramatically.
One-time investors' darling Green Mountain Coffee almost quadrupled during the first nine months of year, peaking at just under $116 in September and forcing many shorts to abandon their bets. But after noted hedge fund manager David Einhorn blasted the company for its accounting and disclosure practices in an October 17 presentation and the company posted an earnings shortfall a few weeks later, Green Mountain shares cratered. They dropped more than 70 percent from the September high, hitting $34.06 in November.
Last month, Einhorn told Reuters he was more sure than ever about his bet against Green Mountain.
Short sellers can bet against a stock for many reasons but among the most common are a belief that the company has accounting problems, its product is a fad that will quickly lose luster, regulatory problems loom, or that it has been overvalued by reckless investors.
But even if the shorts' analysis is correct, it can take many months or even years for other investors to concur, and in the meantime the short seller has the carrying costs of the position and losses if the stock rises.
Bastiat's Meyer, who was one of the first to raise questions about accounting problems at scandal-hit Tyco and Enron, now manages only long accounts. Last year was a difficult one for stock picking on either side of the ledger, he says, because of the way investors reacted en masse to government debt problems in the United States and Europe.
Events such as the U.S. debt ceiling showdown in Congress, which was followed by the U.S. losing its triple-A credit rating, and continuing with a series of European bond debacles from Greece to Ireland, stocks traded in unison for long periods, more than they had in decades by some measures. When stock prices move together, there is less room for fund managers to pick winners or losers.
"Stock picking is challenged when there is this very high level of correlation among stock prices," said Dean Curnutt, president of research firm Macro Risk Advisors in New York. Over the past few months, the prices of the largest stocks in the S&P 500 Index have been as much as 90 percent correlated, a higher level even than during the 2008 credit crisis, he said.
Even investors who used short exchange traded funds to try to play the gloom that hit the European and U.S. economies during the year would have had to time their moves well to end up on top.
That is largely because the shorting ETFs are designed only to track market index moves on a daily basis. The funds have to reset their positions in futures contracts each day, so the results do not track the market over longer periods. For example, the ProShares UltraShort S&P 500 ETF lost 18.82 percent last year even as the S&P 500 itself was nearly unchanged.
Still, the uniform movements may create better opportunities for fund managers later this year, as more stocks may be priced above or below their fair values. "From a stock picker's perspective, it's likely led to many situations where the baby has been thrown out with the bathwater," Curnutt said.
Among the most vulnerable industries in 2012, short-selling fund managers said they are focused on retailers, technology vendors, home builders and financials. Tighter budgets among consumers and businesses could hurt retailers and tech vendors, while home builders and financials continue to suffer from the aftershocks of the real estate price bust.
"With such strong online sales, bricks and mortar retail companies will suffer," said Doug Noland, co-manager of the Federated Prudent Bear Fund.
Noland declined to comment on the fund's individual holdings. The fund was short The Gap, Urban Outfitters and Wal-Mart Stores, according to a September 30 disclosure filing.
Online restaurant reservation service OpenTable Inc, video game seller GameStop Corp and home builder KB Home are currently among the 20 most heavily shorted stocks measured by the percent of shares they have outstanding, according to Starmine data.
Newly public Internet companies such as Groupon Inc and LinkedIn Corp appear overvalued, as well. But the stocks are exceptionally difficult to borrow given there are only a small number of shares trading, which raises the chances of a short squeeze, Grizzly Fund's Swenson said.
"A lot of them look really weak with no earnings and expensive valuations," Swenson said. "But we really couldn't short them."
Swenson and other shorting managers said they are hoping that the macro-focused and crisis-driven markets of 2011 won't be such a feature this year. "It would be nice if we could go back to companies trading based on the fundamentals," Swenson said.
(Reporting By Aaron Pressman; Editing by Martin Howell.)
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