By Justin Lahart
Most investors know that shorting a stock, or betting it will fall in value, is a risky proposition entailing the chance of huge losses. But knowing that is nothing like seeing it in action.
The ramp higher in Tesla Motors Inc. (TSLA) shares in the days since the electric-car maker reported it swung to a profit in the first quarter has served as a vivid reminder of just how dangerous a game shorting stocks can be. It may also signal a shift to a kind of market environment that can prove particularly treacherous for those on the short side.
Even before Tesla reported results last week, investors who had heavily shorted the shares by selling borrowed stock had to be feeling uncomfortable. In the time since the company announced in early April it had beaten its first-quarter deliveries target, its shares had risen 47%. When the stock jumped after the earnings report, the "squeeze" looks as if it got unbearable.
Investors raced to buy back shares they had sold short. That only intensified the stock's move higher, prompting even more pessimistic investors to throw in the towel. Tesla's shares rose 53% in three trading days, taking its market value to a peak of $10.1 billion, from $6.4 billion, before the fever broke Tuesday.
In turn, shares of other heavily shorted companies, like InterOil Corp. (IOC) and Questcor Pharmaceuticals Inc. (QCOR), also rallied. That is an indication some traders are actively looking to buy stocks with high short interest, posing an additional risk for short sellers.
The past several years have had their share of "short squeezes," but few match the scope of what has happened with Tesla. One reason why: It is possible for bullish investors to imagine Tesla becoming a truly huge company in the way it isn't for a company like Sears Holdings Corp. (SHLD)--the subject of a continuing short fight--to become anything more than a healthy retailer.
Moreover, threats that have hung over the economy since the recession ended in 2009 have receded, opening up the possibility of a more robust stage of growth. And that has removed the limits on what investors believe an early-stage company might become. It is an environment more like the mid-1990s than what investors working the short side have more recently been accustomed to.
Indeed, what is happening with Tesla reminds Marc Cohodes, a former short-selling hedge-fund manager now focused on selling the eggs he raises at his farm, of what happened with Iomega in 1996. Iomega was heavily shorted on the (ultimately correct) view that the richly-valued portable disk-drive maker would be swamped by deep-pocketed competition. But Iomega shares shot up 566% in the first half of the year before cresting.
The difficulty with the Tesla short story is that it seems to be built more around the company's heady valuation and a belief the company will falter in the long term than an idea of what specifically will make its stock fall in the near term.
That is dangerous in this sort of market, particularly for stocks like Tesla, which at last count had about 40% of its freely tradable shares sold short. Dedicated short sellers active in the 1990s knew this, or learned it the hard way, but many are no longer on the scene.
And with stocks the only asset class really producing decent returns lately, portfolio managers who more typically invest across a variety of investment products have taken on greater equity exposure. But to make sure their returns aren't too correlated with the stock market, they have often taken short positions.
That has led investors to crowd into many of the same positions. Whenever that happens, the rush for the exit can get ugly.