How This Downhill Investor Doubled His Money Finding bull market prices unbearable, I started selling stocks short last February and survived to recount my bittersweet triumph.
By Junius Ellis

(MONEY Magazine) – On Meltdown Monday I followed my usual route to work down midtown Manhattan's Park Avenue, passing the portals of such blue-chip multinationals as Mercedes-Benz, Unilever, Fuji Bank & Trust, Colgate-Palmolive and ITT. I had no inkling that these and most other publicly held companies worldwide would be worth much less on paper by the next morning. I expected the stock market to rally strongly in response to the previous Friday's 108-point plunge in the Dow Jones industrial average. So did my broker, Stan Trilling, whom I phoned at Paine Webber before the market opened down sharply that day. ''Don't get faked out by the panic sellers,'' counseled Stan, a 19-year veteran. ''Stocks could be much higher by week's end.'' So much for our combined prowess as market timers. Yet unlike many investors whose net worths were slashed by the crash, I walked away from the wreckage on Wall Street a much wealthier man. I've more than doubled my money since last February, when I committed a big chunk of my savings to selling short in the face of the longest bull market in the postwar era. There were periods when I cursed the timing of my decision as stocks kept climbing in defiance of investing gravity, subjecting me to huge paper losses and ultimatums from Paine Webber to bail out or put up more money. But I somehow summoned the resources and resolve to stay the course as a downhill investor and was richly rewarded by what I saw as October's exhilarating schuss to the bottom. Although many small investors may be envious, most are unlikely to emulate my unconventional strategy of sell high, buy low. They probably suspect that only streetwise professional traders profit by selling stocks borrowed from brokers in hopes of eventually replacing the shares with ones bought at lower prices. I am hardly such a pro. As a 37-year-old journalist who worked at Money for two years, I have gleaned most of my insights on the market from writing about it, not from investing in it. If the rating system used for skiers were applied to stock pickers, I would be classified as a fair-weather intermediate: strong on technique, weak on experience and thus reluctant to take risks unless conditions are ideal. The investment climate certainly seemed favorable for short sellers early in 1987. The bull market had extended its winning streak to five years in a row, a feat of hope and hype unprecedented in my lifetime. There were nagging New Year's Day doubts about stocks maintaining momentum amid scandals in the White House and on Wall Street. But they were buried by a blizzard of buy orders -- the Dow rose an incredible 23%, to 2334, by winter's end -- precipitated in part by market guru Robert Prechter's forecast of a 3600 peak in 1988 or 1989. Although tempted by predictions of quick profits, I was simply too cheap to pay the perilously inflated prices most stocks commanded relative to such fundamentals as earnings, dividends and book value (net worth). In this respect I was in the then unfashionable company of Warren Buffett and other diehard value investors, a catchall term for cheapskates who seek out stocks priced well below their intrinsic worth. Buffett, the billionaire head of Omaha's Berkshire Hathaway, lamented last March he could find no stocks that came close to meeting his test for value. His credo: ''If a business is worth $1 and I can buy it for 40 cents, something good may happen to me.'' Surely, I reasoned, this proven approach should be just as enriching in reverse. If a business is worth 40 cents and I can sell it short for $1, something good may happen to me too. Newspaper stock pages were packed with companies selling at historically unsustainable multiples of earnings, dividends and book value. Cassandras of fundamental analysis were all but silenced by the Candides of a new era for equities. Equities? I cringed every time I read or heard this highfalutin buzzword for stocks. To me it was yet another symptom of investors' brazen disregard for the basics. Selling short also presented several practical advantages. Foremost among them, wildly overvalued stocks are easier to spot than are bargain-priced ones. High fliers invariably make headlines or quarterly lists of the market's top performers, inviting scrutiny. Many are so-called story stocks that brokers, analysts and journalists love to promote as beneficiaries of new trends -- specialty retailing, desktop publishing and cellular mobile phones were prominent ones last year. Alas, the story is usually more compelling than the companies' histories of earnings or revenues, which pundits and stock peddlers tend to downplay as long as the stock prices keep heading up. What's more, short sellers have few competitors. The market's dominant players -- pension and mutual funds and other institutions -- are almost always prohibited from shorting stocks. Most individual investors and their brokers are card-carrying optimists. The field is thus reduced to a small cadre of professional short sellers (who may number fewer than 50) plus a thousand or so brokerage house traders who short stocks for their own accounts as well as their firms'. As I see it, this paucity of contestants greatly enhances my chances of profits. If selling short were widespread, particularly among institutions, they could be expected to pounce en masse on obviously corpulent stocks, knocking down the prices to much leaner levels before I could act. There is another reason why my strategy isn't popular. Because short sellers appear to profit from others' pain, they are often ostracized as the stock market equivalents of ambulance chasers. Such puritanism rings hollow on Wall Street, however. I can't imagine anyone shunning Citicorp chairman John Reed last Sept. 16, when he celebrated his bank's $1 billion public stock sale at $29 a share, adjusted for a stock split. Nor do I recall anyone chiding him for offering on Oct. 20 to buy back Citicorp at crash-adjusted prices as low as $16 -- a fat 45% profit per share for the bank. My wife Lisa's reaction to my first short sale last February is typical: ''There must be more respectable ways to play the market than dancing on the grave of capitalism.'' Yes, I said, but most of them carry the risk of buying stocks at raging-bull prices that one day will seem foolishly farfetched. ''Perhaps,'' she conceded, ''but why take the greater risk of shorting a stock that could double or triple in price before the market peaks?'' She almost had me there. Since most short sales are made on margin -- only 50% of each transaction is secured by cash or securities held in my margin account -- my profits or losses would be double in magnitude. (That would also be the case if I bought stocks on margin.) But margin accounts have a built-in damage-control system. Let's say I shorted stocks with a total value of $1,000, putting up $500 in cash to secure the borrowed shares. If the value of my portfolio declined or increased $100, I'd show a 20% (rather than 10%) gain or loss on paper. If, however, my loss grew larger than $150, or 30% of my collateral, my broker would confront me with a margin call. This is an ultimatum via Mailgram to put up more cash or to buy back (or cover) enough shares to restore my account's equity to the brokerage's minimum, usually 30%. To allay my wife's anxieties, I promised to pick my shorts carefully and pointed out that I would be working closely -- albeit by long distance -- with Stan, an experienced broker who is a senior vice president at Paine Webber in Los Angeles. In recent years I had come to rely on him as one of my best sources on stock value, as well as the lack of it. When Stan recommended a company as a buy or a short sale, I knew he had researched it thoroughly and taken a position in it himself -- rare attributes among brokers these days. When I suggested a short sale, he took the time to check it out before weighing in with his yea or nay. Without Stan's guidance, the following episodes in my brief career as a bear would have been more grisly and less gainful.

WRETCHED EXCESSES On Feb. 19, with the Dow at 2244, I phoned Stan to say I was ready to begin my apprenticeship as a short seller. I had done my homework, having assembled a two-inch-thick folder of candidates collected from news clippings and cross- referenced by Standard & Poor's stock reports. I called the file Wretched Excesses to Watch; it was weighted with flighty over-the-counter companies on the assumption that they were least likely to become takeover targets -- the bane of short sellers. My initial gambit focused on companies whose market values -- but not earnings or revenues -- had soared solely because their products promised to thwart the transmission of AIDS. As we talked, Stan helped me single out two stocks whose prices were way out of line with their AIDS-fighting potential: Daxor (my first short sale, at $28.75 over the counter) and Mentor ($18.50, OTC) four days later. Daxor, which traded for less than $6 in early February, had smitten speculators with its cryogenic technique for stockpiling customers' frozen blood for up to 20 years, thereby avoiding the risk of contracting AIDS from transfusions of other donors' blood. Yet the American Red Cross, the leader in frozen-blood storage, had criticized Daxor's service as impractical or unnecessary for most patients. ''The stock was overpriced at $6,'' growled Stan, who had made a research call on Daxor in late 1986 and joined me in shorting it. (For the ultimate outcome of this and other short sales, see the table on page 102.) Mentor, a new entrant in the condom market, had risen from around $8 in November 1986, when Surgeon General C. Everett Koop endorsed condoms as the best AIDS defense short of abstinence. But even if condom sales took off -- which Stan and I doubted -- puny Mentor would have to fight for shelf space against such heavyweights as Carter-Wallace in the U.S., Okamoto of Japan and Britain's London International. Other early short sales included Texas Air and Genentech. I shorted Texas Air (American Stock Exchange, $50) near its all-time high of $51.50, a preposterous price for the debt-ridden and ineptly managed parent of Eastern, Continental and the late People Express airlines. The flight delays and cancellations that plagued those carriers were painfully obvious to passengers. Despite those problems, Texas Air was a big institutional favorite. It then sold for about 75 times earnings, vs. a price/earnings ratio of 13 for American Airlines, the industry model of service and efficiency. Genentech, the IBM of biotechnology, had tripled in price from January 1986 to Feb. 23, 1987, when I sold it short at $53 (OTC). That heady ascent was powered largely by analysts' euphoric forecasts of $1 billion annual sales for Activase, an experimental drug that dissolves blood clots that cause heart attacks. But it was I who had palpitations in late February as the final stage of frenzied buying boosted the stock to $60 -- where I hit the panic button, covering my short sale at a 29% net loss -- en route to an apogee of $65.25 and an astronomical P/E of 375. My fright of passage as a short-seller cadet miffed Stan, whom I had not consulted because he was away on business. ''You should have sat tight or doubled up your position at a higher price,'' he scolded me. ''Genentech will fizzle soon.'' Stan was right. The stock fell as low as $36 in June on news that Activase had failed to win approval from the Food and Drug Administration. When the drug received the FDA's go-ahead on Nov. 16, Genentech had recovered to $42. Meanwhile, analysts' estimates of Activase's sales potential had quietly been cut in half to $500 million. The stock recently traded at $42.

PACIFIC BASIN PREMIUMS In March I took fairly large short positions in two closed-end stock funds: Korea Fund (New York Stock Exchange: my average price: $64.25) and Taiwan Fund (ASE, $33.70 average). Both had nearly doubled in price since year-end 1986, as more and more investors discovered the booming Pacific Basin, a longitudinal slice of Asia that is dominated by Japan but also includes up- and-comers South Korea, Taiwan and Hong Kong. Never mind that the people of Korea and Taiwan were generally underpaid, overworked and disfranchised; military strongmen had long run the countries and their protectionist economies. What is special about these two stock funds is that they are monopolies. Each is essentially the only vehicle available to Americans keen to invest in fast-growing, export-driven Korean and Taiwanese companies. But the price of admission was steep. Investors who bought the Korea shares I sold short in March paid $64 or so for a stock portfolio worth $31 a share -- a premium of 107%. Those who bought Taiwan from me were even more generous, paying nearly $34 for a portfolio worth about $13 a share, a 162% premium! Shares of prosperous U.S. companies often sell for such premiums to book value, the equivalent of a mutual fund's net asset value. But that is rarely the case with closed-end funds, which usually sell at a discount to net asset value. In late March, for example, I could have bought the closed-end Japan Fund (now a conventional, or open-end, fund) for $19, a discount of 7.6% from its portfolio's $20.42 value per share.

BEAR CUB TRAP My short selling waned as the days lengthened from April to mid-June and the Dow seesawed aimlessly between 2400 and 2200. I had pretty much run out of money to invest; in late April I was ahead about 24% overall and had a short portfolio of 15 stocks. In addition to the five mentioned previously, they were NYSE issues AMRE, Chemical Waste, Humana and United Asset Management; OTC stocks Applied Bioscience, Copytele, Fingermatrix, Oracle Systems and Western Waste; and the ASE's Ecology & Environment. I reviewed my options: wait for the sell-off that was overdue, or take profits and short more vulnerable stocks. I chose the latter course, as much out of boredom as conviction, and covered Daxor at $13.25 (a 102% net gain), Mentor at $13.50 (47% gain), Texas Air at $37.25 (45% gain), as well as AMRE (29% gain), Fingermatrix (15% gain), Applied Bioscience (2% gain), Humana (4% loss) and Western Waste (15% loss). Copytele, which I shorted at $15 in mid-April, was now my biggest winner, with a 40% paper profit. The company went public in 1983 and has lost money ever since in its unsuccessful attempt to develop a flat-panel video screen for use on portable computers. Yet this hapless high-tech, with no product and a negligible net worth, was valued by the market at about $160 million. Red ink also gushed from AT&E (ASE, $29), which I sold short in early May. It had a market value of $185 million or so but a paltry book value of $5.3 million, or 80 cents a share. Investors had prodigious expectations for the firm's latest product -- a Dick Tracy-esque wristwatch with built-in electronic ''beeper.'' The gizmo would allow wearers to be paged via FM radio waves to phone home, the office or the bucket shops that shamelessly push such gimmick stocks. I expected that both of these companies would eventually go bankrupt. I still do. In early June, I shorted Metro Mobile CTS (OTC, $23.25), a debt-ridden firm whose interest expense alone exceeded revenues in fiscal 1986. The CTS stands for cellular telephone systems -- as in car phones -- a growing but capital- insatiable business that could be unprofitable for years. Yet these stocks were the rage on Wall Street for no reason that made sense to me save for brokers' fetishes for car phones and other trappings of life at the top. (Stan is an exception. Says he: ''I'm a bad enough driver with both hands on the wheel.'') Another hot stock group -- one that Stan follows -- was the asbestos cleanup industry. Following his lead, I shorted Commodore Environmental Services (OTC, $6 average), a corporate shell set up to issue stock and borrow money to finance acquisitions of asbestos-removal contractors. Commodore had scant earnings and revenues. But its $275 million market value dwarfed that of profitable competitors, such as Brand ($83 million) and Control Resources ($76 million), both of which had recently reported earnings below analysts' projections. Stan was sure Commodore would disappoint analysts too -- and soon. My biggest frustration thus far was Korea Fund, whose price had held firm despite that nation's simmering social unrest. Then in June the country boiled over as massive student demonstrations calling for democratic reforms were met by legions of tear-gas-lobbing riot police, leaving three dead. Amid rumors that a military-led crackdown on protestors was imminent, Korea Fund dropped to $56 on June 19, off $11 for the week and 25% on my short position. Anticipating that the fund would fall much further and drag down the Taiwan Fund with it, I wasn't unduly concerned that the market -- and most of my other shorts -- had started moving up. If a summer rally was in the making, I had enough cash to ride it out and even sell short into it. Or so I thought.

SHORT SQUEEZE My summer suddenly got very sticky on July 1, when Korean dictator Chun Doo Hwan did an abrupt about-face by calling off his storm troopers and agreeing to consider political reforms demanded by democratic activists. That week Korea Fund shot up $10 on its way to $86 and change on July 19, a 54% rise from its June low that left me with a 69% paper loss on my short position. Now for the bad news. A fortnight following Chun's concessions, his counterparts in Taiwan lifted that country's 40-year-old controls on currency outflows, inciting a buying riot on the Taipei bourse. In the subsequent three days, Taiwan Fund zoomed from $33 to $54 before settling at $49 on July 19 -- a 91% paper loss for me. Cross my heart and hope to buy, I did not panic initially. Still smarting from my costly loss of nerve on Genentech, I told Stan to double up my short positions in both stock funds. It wasn't until he called back to say no shares were available to borrow that claustrophobia began to close in. A bare cupboard of loanable Korea and Taiwan shares was a sure sign that too many traders had shorted the stocks in June and were now caught in a short squeeze, every bear's nightmare. In a short squeeze, a stock's price rises sharply as more and more short sellers are forced to cover their positions, jacking up the price as they buy back the stock. Pressure to cover can come from brokers, who demand return of borrowed shares for original owners wanting to sell into the run-up, or from margin calls against battered short-sales accounts. My wife was not sympathetic. ''It's about time you did some Seoul searching,'' she quipped, unaware that my losses (related as well to Taiwan and the mounting summer rally) had plunged my margin account balance into the red for the first time. My response was to raise cash immediately on July 20 by covering one of my big winners, Copytele, at $10.25 (for a 58% profit) and two less dramatic successes, in hopes my main squeezes would ease soon. When they did -- Taiwan shares could be borrowed as early as July 24 -- I didn't hesitate to double up on Taiwan at $45 (resulting in a new average price of $39.25) and Korea at $84.25 ($74 average). But I should have.

THE BROKER RINGS TWICE I was already teetering on the edge of defeat when the mild summer rally turned into the August thermal that lofted the Dow to its 2722 summit. This updraft of indiscriminate buying convinced me that the market had passed the point of no return, oblivious to such earthy realities as rising interest rates and slumping bond prices -- harbingers of an inevitable recession most investors refused to heed. I was sure that a big correction would rescue me if only I could stay hunkered down long enough. The Mailgram announcing my first margin call arrived Aug. 7. ''Dear Client,'' it began. ''Recent market conditions have reduced the equity in your account below the required minimum.'' I knew that the letter was coming and that my losses totaled more than 30% of my collateral, including reinvested profits. Stan had called the day before to alert me and advise me to up the ante rather than to cover any of my six remaining short sales -- all but one of them losers. I sent in a check for $10,000, hopeful that amount would see me through. It didn't come close. My second ''dear client'' Mailgram arrived Sept. 2; my shorts had continued to rise after the Dow peaked on August 25. Down more than 30%, I wasn't keen to put up more money. Instead, I met the margin call by covering my only winner, AT&E, at $16.75 (an 80% gain). My pathetic portfolio now consisted of Korea Fund (I was down 20%), Taiwan Fund (down 63%), Metro Mobile (down 21%), Commodore (down 57%) and Organogenesis (down 25%). Organogenesis, which I first shorted in early July (OTC, $21.25 average), is a start-up biotech concern that makes replacement skin and arteries cultured from human cells. The technology is promising. Marion Labs is clinically testing artificial skin, which the giant drugmaker projects has a $110- million-a-year market for uses in plastic surgery and burn therapy. In contrast, tiny, undercapitalized Organogenesis hasn't conducted any clinical tests and thus can't be expected to have an FDA-approved product for at least six to eight years. I might have received another margin call in September were it not for Korea Fund's providential fall to $75 -- where I covered for a 6% loss -- amid strikes and riots by that country's workers. I was glad to be rid of this manic-depressive stock fund, which freed up a big bundle of collateral and, true to form, popped up again to $81 a week or so before the crash.

LONG SQUEEZE My day finally came. The margin calls that nearly wiped me out were tame compared with the bear hug that crushed the bulls in October. As the market collapsed, stock-laden institutions decided all at once to take profits that they should have been taking steadily for months. But these big holders discovered a dearth of buyers for shares or stock index futures, which money managers mistakenly believed would hedge, or offset, losses in their portfolios. Hence the term portfolio insurance. Faced with a Hobson's choice of holding unhedged stocks or selling them, many institutions dumped shares on the market, depressing prices further, triggering marketwide margin calls and accelerating panic selling at whatever price could be had. Although I didn't anticipate the crash, I wasn't caught entirely flatfooted by it. A week or so earlier, my shorts had declined enough to put my margin account solidly back in the black. So I again sold short Copytele, starting at $12, on the assumption that a potential bankruptcy was the safest short in an oversold market. I doubled up on that assumption later in October, shorting the stock for the third time in six months at an average price of $9.25. Copytele, however, was my only short sale in October. Instead, I watched my profits pyramid while waiting anxiously to see whether the market would set the new lows that usually presage post-crash rallies. Another concern was paying taxes on my escalating winnings. All short sales are fully taxable; they do not qualify for the preferential rates that, prior to 1988, were afforded long-term capital gains. So any profits I took in 1987 would be taxed at my 38.5% marginal rate vs. 28% this year. The solution was a nifty maneuver, suggested by Stan, called long against the box. That's brokerspeak for short sales fully hedged by matching long positions bought at lower prices. For instance, on Oct. 28 I locked in a 89% net gain on my $39.25-a-share Taiwan Fund short sale by buying the same number of shares at $21. I also went long against the box on Commodore (101% gain) and Metro Mobile (81% gain). But because I didn't replace any of the shares I had borrowed, my profits could be deferred until I told Stan to cover my short sales with the corresponding shares I owned. No extra commissions would be paid; the swap is simply an accounting matter. I let my profits run on Copytele and Organogenesis, which I believed would fall well below their respective October lows of $3.25 and $6.50. In fact, when Organogenesis rebounded smartly in November, I pulled out all the stops. I tripled up on my previous $21.25-a-share short sale, selling the resurgent stock at $12.75 on average to amass two positions that together marked my initiation into the six-figures league. (The stock recently traded at 13.)

EPILOGUE Emboldened by locked-in gains exceeding my investment, I was no longer a small timer whose stomach churned when I placed orders of 1,000-share multiples. Such trades were now routine, regardless of a stock's price. For example, Oracle Systems was an early $12-a-share short sale that I covered in July for a small profit. When, beginning in November, I re-shorted this overvalued software firm at $12.50 on average, my position was more than eight times larger. (Oracle recently traded at $14.50.) % Otherwise, my strategy has changed little since the crash. I still think most stocks are overpriced, though they could get pricier if the market makes a valiant last stand before resuming its disorderly retreat into recession. So I plan to stay short for the long term, selectively adding to existing positions and shorting new stocks whose flanks are exposed. Plenty of cash is at my disposal. As of Dec. 18, I showed a net gain of 175%, compared with a 12% decline in the Dow, since Feb. 19. Stan didn't do badly by this short seller either, sharing with his firm commissions totaling about $12,000. My wife was impressed but impatient. ''Promise me that you will start cashing in soon,'' she said in mid-December as the market staged a year-end rally. I dodged the issue by mumbling something about the huge tax bill that would entail. I didn't have the nerve to tell her then that my adventures as a bear were just beginning.

CHART: TEXT NOT AVAILABLE CREDIT: NO CREDIT CAPTION: MY REWARDING CAREER AS A BEAR This table of my 1987 shorts sales, compiled by the New York City accounting firm Mitchell Titus & Co., shows the 18 winners and seven losers that produced my 10-month net profit of 165%. The analysis is adjusted for stock splits and assumes that profits locked in but deferred to 1988 were realized. Open short positions are as of Dec. 31. DESCRIPTION: See above.