The Dow Jones industrial average was down 80 points, the S&P 500 was lower by 12 and the Nasdaq closed down 24. Not to mention, my meager portfolio was bleeding red on the session. I had only been actively investing for several weeks at the time and couldn't understand how I managed to lose money on the same day my friend made a killing.
Curious, I asked him how he managed to make a big score when the market was trading sharply lower across the board.
"I love big down days. It's how I make my money," he replied.
"How is this possible?" I asked myself. Desperate to learn more, I pushed him for his secret. He seemed incredulous that I didn't know that an investor could make money during the down market.
He explained that he was a short seller during market sell-offs. I had heard of short selling but erroneously believed that only large banks and financial institutions could effectively pull it off.
Boy, was I wrong.
In fact, anyone can take advantage of short selling. My friend went on to explain this simple process.
When you expect a stock's price to drop, you borrow shares from your broker at the agreed-upon current price. You then hold these shares in your account, waiting for the price to drop. If, as you expect, the price drops, you can then sell the shares back to your broker while keeping the difference between the price at which you borrowed the shares and the current market price the broker has to offer.
Short selling is a highly effective method to profit from falling stock prices, but can be risky and is only suitable for more advanced investors who understand the risks involved, which I'll mention later.
I've found two stocks that could make excellent short candidates for your portfolio.
1. Apollo Group (Nasdaq: APOL)
This for-profit educational company has been in an extended downtrend since January of last year. Slipping from a high near $60 to the current trading price in the $17 range, this downtrend has been custom-made for short sellers since its inception. The company's recent quarterly report surprised the Street with earnings per share of 34 cents, which beat analysts' estimates of 18 cents, but shares continued their downward spiral.
Net revenue for the second quarter came in at $834 million, down more than 13% from the same quarter last year.
Degreed enrollment at the University of Phoenix, which accounts for 90% of Apollo's revenue, slipped more than 15% to just under 301,000 students. In addition, new degreed enrollment fell more than 20%.
For-profit educational institutions were once the darlings of Wall Street. But falling enrollments, increased regulations and the brewing student loan debt crisis have created a very difficult operating environment. Combine the fundamental deterioration, strong economic headwinds and the downtrending technical picture, and it all adds up to a classic short. Waiting for support in the $15 range to break makes sense before entering shorts.
2. Chipotle Mexican Grill (NYSE: CMG)
This company is the polar opposite of Apollo Group on the chart. It has been in an uptrend since hitting a bottom in October last year.
After surging nearly 100 points from lows in the $240 range to near $340 within seven months, this stock has become a top performer.
I am not alone with this assessment. Famed short seller and hedge fund manager David Einhorn is also a vocal short seller of the food chain. But it's not the fundamental or technical picture that paints a bearish future for Chipotle. It's Wall Street's high expectations combined with climbing food prices, sky-high valuations and increased competition from Yum Brands' Taco Bell restaurants.
But it's critical to note that Chipotle has increased its revenue an impressive 22.8%, free cash flow by 133.6% and book value by 17.3% annually during the past five years. Those are truly amazing numbers.
But what catches my bearish eye is the recent slowdown in sales. In 2012, comparable sales slipped quarterly from 12.7% in the first quarter, 8% in the second quarter and 4.8% in the third quarter.
There is no question about it: Chipotle has great food, but its menu doesn't offer a wide enough selection to keep customers from becoming burned out on its offerings. I think this could be to blame for the company's declining comparable sales. "Restaurant fatigue" can happen to anyone, as even the best food can become less appealing if you eat it often enough.
Technically, shares have been in a strong uptrend. Therefore, the best way to approach a short is to wait for the selling to commence before entering the position. This means being patient and waiting for the stock to snap support at $315 prior to shorting.
Risks to Consider: There are risks to shorting stocks. Being caught in a short squeeze is one. In addition, theoretically, stocks can go up forever, but they can only go down to zero. Therefore, short positions have theoretical unlimited risk. You can manage the risk by always using stops and position sizing properly before shorting any stock.
Action to Take --> I like both stocks as short candidates once the support levels are broken. My 18-month target on Apollo is $3 while Chipotle has an 18-month short target of $175. Remember, these targets are valid only if the short entry is triggered by breaking of support in each stock.
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