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The Amateur / Vad Yazvinski5/21/2008 12:01 AM ET

A secret, winning hedge-fund recipe

Here's why investors and the market will be much better off if they get over the apprehension with short-selling stocks.

  • Sell entire position in ValueClick (VCLK, news, msgs) and Vasco Data Security International (VDSI, news, msgs) at the open.

  • Sell half of my position in Fushi Copperweld (FSIN, news, msgs) at the open.

  • Sell 40% of my position in China Natural Gas (CHNG, news, msgs) at the open.

  • Invest any remaining cash in Vanguard Mid-Cap ETF (VO, news, msgs) at the open.

Strategy Lab is MSN Money's stock-picking challenge. To learn more about the game -- and the contenders -- click here.

"Growth for the sake of growth is the ideology of the cancer cell"

-Edward Abbey

Various versions of the "Is this rally for real?" headline are becoming a staple in the mainstream media. Everyone and their mother is now asking this question and stating why it is or it isn't the case.

Here is a simple fact to consider from the un-opinionated Skeptical Capitalist: the Dow Jones Industrial Average ($INDU) and Nasdaq Composite Index ($COMPX) are up more than 10% since the market bottomed in March! Given the fact that this double-digit gain is most likely significantly larger than the average annualized return passive investors should expect over the long haul, why in the world would anyone question if this rally is for real? Giving up a double-digit return for any reason in my book is simply irrational.

This rally is exactly the reason why I have been arguing passionately for a while now that successfully timing the market is quite difficult to achieve over the long haul, and thus an average investor should never move all holdings into cash. When you are unsure about where the market is heading, it could much more prudent to move your cash into index ETFs, like Vanguard Mid-Cap ETF (VO, news, msgs), Vanguard Large-Cap ETF (VV, news, msgs), Standard & Poor's SPDR Trust (SPY, news, msgs) and Nasdaq-100 exchange-traded fund (QQQQ, news, msgs) than into cash or money-market funds that don't even earn a high enough return to compensate for inflation. And if you are a true active investor, consider using short positions.

Forget the short-selling stigma

Remember there is nothing wrong with being negative about a stock. It is perfectly ethical to give management a run for their money by questioning their silly actions and voting your dissatisfaction by selling shares. I actually think that if the "negative stigma" attached to the cruel "short selling" practice disappears, average investors will be much better off because the market will become more efficient.

Just imagine how much wealth was irrationally shifted from investors' accounts into the pockets of newly minted dot-com millionaires during the tech boom, just because speculative actions of the bullish investors went unchecked by the widely outnumbered and heavily criticized bears. The same thing occurred with subprime lenders and homebuilders in 2006 and 2007.

If only investors out there finally realized that instead of listening to the "whining CEOs" blaming evil "short sellers" for manipulating their stock prices, they could do much better if they listen to what these "evil" hedge-fund managers are actually saying. While obviously short sellers aren't always right, they are more often right than wrong and high short interest usually indicates either temporary overvaluation of the stock itself, or could even point to a fundamental flaw in the underlying business model of a company that seems to be doing fine on the surface.

The reason for this phenomenon in my mind is quite simple. In a world where investing is now easily accessible to anyone with a computer and an internet connection, the real edge comes from doing what most regular investors are still afraid to do: shorting stocks. This in turn implies that investors who short stocks are, on average, much more sophisticated than the ones who do not and thus their advice is likely to be more valuable. That is precisely the reason why "Vad's secret hedge fund recipe" pays a lot of attention to a widely underappreciated indicator: -short ratio.

A recipe for successful shorting

This ratio represents a number of shares of a particular stock that are shorted, divided by a stock's average daily volume over a certain period of time (usually 30 days). For example, I use it on both sides of my investing strategy. When searching for stocks to short, I simply avoid starting a full position until the short ratio moves above seven days. It is only one of the factors I take into account when making a decision to short a particular security, but it is definitely one of the more important ones.

On the long side, after my mechanical screening process identifies the top picks, I go in and manually dig through all the available bearish information on each stock with a short ratio of over seven. If I can't figure why the stock is disliked, I simply don't buy it. On the other hand, if the short ratio is high and I think I know why, the pick becomes a part of my contrarian "conviction" bet group with the appropriate allocation of no more than three to four positions and 15 to 20% total maximum weighting for the high short ratio group.

As an example, my original "conviction" pick, Fushi Copperweld (FSIN, news, msgs), carried relatively high short ratio. But to me, it was pretty clear why. Investors simply did not believe that management could deliver on its growth promises, and also questioned the rationale of the stock dilution required to complete a key deal. But I decided that not only was the fundamental growth story clearly intact, but also that management has not shown any reasons whatsoever to actually doubt its business acumen. Thus, the shorts were likely to be wrong. It is not clear who is going to be right in the long haul, but to me a more than 35% return in just a few months is nothing to sneeze at.

It is true, that I could have theoretically shown returns much better than the more than 18% I've enjoyed so far by focusing on a small number of "conviction" picks, as I have now selected a very long list of 35% growth winners on both short and long side. But in my "actively hedged" strategy the main focus is risk-adjusted returns, which by default means a higher number of picks and a consistently significant short position. This strategy has worked for me so far and I have no intention of changing it.

Going professional

On another note, I have been relatively quiet recently as I am currently in the process of officially changing my status from the "amateur" to a real "pro." Beginning June 1, I will finally combine all of my skeptical capitalistic ideas into one full fledged hedge fund launched with a "back office" support of my current employer. Hopefully, given the fact I can now focus all of my efforts on the actual portfolio management; my track record will only get better as time goes by. In the meantime, I will also devote much more attention to building my blog, SkepticalCapitalist.com, into a useful resource for any active investor who is looking for some good monthly long and short investing ideas and unbiased economic and investing educational commentary.

For now, stay safe and please feel free to e-mail me with any questions at skepticalcapitalist@gmail.com.

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