Two Reasons to Value the Dark Side of Stocks

We called him "Darth Vader"...

He loved discovering the "dark side" of a stock.

He'd get incredibly excited about explaining why a stock was going to fail. He loved mapping out the downside, and he reveled in finding a company's "warts" before the rest of the world saw them.

Most people don't like the idea of short-selling – betting that a stock will fall. You might feel uncomfortable with it. And even if you don't, you almost certainly don't have this investor's passion for exposing a company's hidden defects.

Nevertheless, shorting stocks is a valuable skill. So today, I want to talk about this investor, and the two key benefits of his unpopular approach...

From 2009 through 2013, I ran a hedge fund in New York. During that time, I often attended investment-idea meetings. My favorites were the ones hosted by legendary investor Julian Robertson.

A group of us met every other Tuesday on the 48th floor of 101 Park Avenue for lunch. We talked about what we saw going on in the world... data points from the companies and business leaders with whom we were close... and macroeconomic factors that made us bullish or bearish.

But mostly, we "talked stocks." We pitched our favorite names to see if other investors agreed with our theses or if they'd poke holes in them. A core group of us made just about every meeting... including Darth Vader.

I mention Darth Vader for two reasons. No matter your investing style, you can gain a lot from looking at the dark side of stocks...

First, to really know the bull case on a stock inside and out, you need to know the bear case – the dark side – just as well.

Far too many investors suffer from "confirmation bias." They formulate a positive thesis on a company and then work to find only the information that will prove they're right. And they tend to interpret new data points as confirming their pre-existing beliefs... whether they actually do or not.

A better approach is to channel your inner Darth Vader. Seek out the dark side of a security. Understand all the reasons not to own the company you think you like so much... and then see how they stack up against the reasons to own it.

This exercise will make you a better long investor. Remember, every time you decide to buy a security, someone else is making the exact opposite decision to sell it. Knowing why can be incredibly helpful. It may keep you from buying a stock you only feel "OK" about.

Plus, if you do the extra research, get a solid handle on the bear case, and find that you still want to buy it... then you know you have a likely winner. And that conviction will enable you to make better decisions when markets get choppy.

The other reason to talk about Darth Vader is to get past the discomfort with shorting and see how it can improve your results...

At the lunches I attended with Vader over the years, most of my investment pitches were long investments. Virtually all of his were shorts.

Again, you may dislike the idea of selling stocks short. You might think it's nasty or mean-spirited. Maybe you've never done it before, and you don't really want to start. Or maybe your main investment vehicle doesn't allow for short-selling (like an IRA or 401k).

But I urge you to break through whatever has held you back because now, more than ever, is the time to get comfortable with this style of investing...

Shorting stocks is a critical tool for managing risk, protecting your portfolio, and even profiting during weak times in the market.

And while a market crash isn't imminent today, we are closer to a peak now than we've been in years.

Open up an account where you can short stocks. (For what it's worth, I think it makes sense to have more than one investment account anyway, as some brokers do certain things better than others.) Short just one share to get the hang of it.

You don't have to fall in love with short-selling... or make it your specialty. But once you get comfortable with it, I think you'll find it's an essential part of a smart investor's toolkit.

Good investing,

Austin Root

Further Reading

"If you're like most investors, you've never considered short selling before and are uncomfortable with the idea," Porter Stansberry writes. "Shorting stocks is a critical tool to protecting your portfolio... and profiting... in a volatile market." Learn more about the strategy right here.

"For the sake of your long-term wealth, you must allocate part of your capital base to measures that will help protect the whole in the event of a sharp market downturn," Austin says. Learn about two more ways to reduce risk in your portfolio here: Follow These Steps to a True 'All Weather' Portfolio.

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Once you've decided to go long or short a stock, the next crucial decision is even more important. And getting it wrong could devastate your portfolio...

Market Notes


Today's chart shows how much you can gain when a bad stock gets "less bad"...

Longtime readers know Steve's "bad to less bad" strategy. After a company's shares have plunged, even a partial recovery can mean a huge rally. You can find these opportunities when investors get over sudden fears, or when a struggling company finally posts some decent news. That's what we're seeing today...

Avon Products (AVP) is a 133-year-old beauty company. Its "multilevel marketing" system means Avon largely counts on 5 million independent representatives to sell its goods. The company lost money in four of the past five years on this outdated approach... But now, Brazil-based Natura has agreed to buy Avon early next year. And in the most recent quarter, Avon lost just $19.5 million on $1.2 billion in sales, beating Wall Street estimates.

That's still not great... but it's less bad. And while AVP shares are still far below their highs, they've tripled from their December lows. Once a stock is left for dead, it doesn't take much for shares to soar...