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Short Selling Gone Wrong




Here's a cautionary tale about short selling. I have, on my hard drive, a market report on Peloton, the stationary bike company, which calls for the stock to decline to $5 per share. The author is prominent short-seller Andrew Left, writing as Citron Research, whom I have followed since he exposed bogus financial reporting at Valeant Pharmaceuticals in 2016. Valeant promptly collapsed. My clients didn't hold any Valeant directly, but we did hold shares in the Sequoia Fund, which were dented by Valeant's implosion. That's how Citron first came to my attention. I began to follow on Twitter.


The report on Peloton is dated December, 2019. I remember reading it the first time and thinking, "Wow, Citron is going to do it again." The report focused on the fact that a $2,245 Peloton is just a stationary bike with an Ipad welded to the front. It's not even a real Ipad, rather a third-party touchscreen which only receives the Peloton feed. You can't watch Netflix, for example, or check your email, while cycling.


Anyone could make this. Anyone could also make the videos which accompany the bike, for which the company charges $39 per month in perpetuity. Citron predicted that lower-cost competitors would flood in. Yet at the time, Peloton enjoyed a valuation in the marketplace, per subscriber, 17 times higher than Planet Fitness, Fitbit, Netflix, Spotify, Stitch Fix, or anything else to which you might subscribe.


Peloton stock (symbol: PTON) traded at about $30 at the time, so a move to $5 represented a crash of 83%. But, two months later the pandemic hit. We all went home to work, and millions of us bought a Peloton. Between 2019 and 2020, company revenue doubled, and then doubled again in 2021. Rather than collapse, PTON shot to $160.


Imagine, just as an exercise, that a smart investor read the report and took a short position in PTON at $30. Further imagine that he sold short 300 shares, equivalent at the time to $9,000 in stock. When the stock hit $60, this short-seller lost all $9,000. When the stock hit $90, he lost $18,000 and when it hit $160, he lost $39,000.


That's what's wrong with short selling. You have an opportunity, if things go perfectly, to make $9,000, against a risk of losing $39,000, maybe more, if one small thing goes wrong. Who would take that bet? You can cover your short position when you see the market go up, in an effort to manage your loss, but good luck trying to time those ins and outs such that you ever make anything. Not only does the risk vs. reward of this trade intrinsically stink, to sell short successfully, your timing must be perfect. Don't try it.


Today, Peloton revenue has collapsed by more than half. Everything which Citron foretold has come to pass, and the stock hovers near $10. $5 looks eminently achievable. The company has announced a new financing round and conceded that it may close entirely if it can't raise more capital.


Moral: when you sell short, you dice with death, even if you are in possession of impeccably correct information.


I don’t really worry that you want to take short positions in stocks. Most of my clients are only vaguely familiar with the practice, if at all. No one has asked me about short selling.


I mention the story because it invites a meditation on the gap between what we think we know, and what we really know. There’s a difference. Unknown unknowns (aka unk unks, black swans, 10 sd events, acts of God) are numerous and dangerous. Yet we can’t even think about them, nor list them, nor reflect on the risks which they pose to our investments. I think that we minimize their consequence and stride into business way over-confident as a result, as this example illustrates.

Here are some things which I think I know (a partial list):


  • Inflation, not deflation, is the primary risk to your retirement. In a fractional reserve banking system such as our own, presided over by a Federal Reserve, which answers to Congress, the risk that this system will err to the side of inflation is high. High, but not 100%. All of these institutions were in place at the onset of the Great Depression.

  • To retire in comfort and security, you should choose investments which protect you from inflation. Stocks and real estate are two good choices. Bonds are terrible, used only as a last resort, with the possible exception of those which adjust for inflation.

  • Diversification protects you from the risk that an individual investment will fail, something which happens all the time.

What do I really know? That’s very hard to say. I know that I love my family and friends. I know that I appreciate my clients, who keep me going in business. After that, I’m not sure.


Here’s a second moral to the story: hardware is an absurdly difficult business. Apple, uniquely, appears to have figured it out. But Apple is the exception which proves the rule. HP bumps along, helped mostly by printers, Dell had to go private to survive, GoPro has experienced three scattered years of small profit in the last ten. Now Peloton has collapsed. The Dyson Vacuum Cleaner Company is said to do well, but we don't know because it is privately held. I see less expensive, knock-off Dysons all over the place. None of these companies can shield themselves adequately from imitation and cutthroat competition to earn more than the tiniest profit, if any at all.


Hardware only works if you have protection, such as an FDA license to sell a medical device or an FAA license for aviation products. HP protects itself by almost giving the printers away, then charging a high price for the proprietary replacement cartridges.


Does Andrew Left of Citron make money selling stocks short? Who knows? That is his private affair. I'll bet that he was wrong-sided on Peloton just like everyone else. Why he would make a career of this is anybody's guess. He sure does write good research though.



Disclosure: The author and his clients hold some shares of Apple, but none of the other companies mentioned in this blog post.

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