Sure Shot Shorts

With the stock market in a state of--pardon the expression--gridlock, some smart investors are making money by picking the best stocks not to own. That shadowy cadre of naysayers, the short sellers, is staging a remarkable comeback. Even though the market has avoided major declines and has eked out an overall gain, short selling partnerships have seen their portfolios rise by a handsome 15% through the third quarter.

The advances made by the shorts are a triumph of adroit stock-picking under adverse circumstances. Short selling is the sale of borrowed stock, in the hope of making money by buying it back at a lower price. Although short selling comes into its own during major market setbacks, shorts have lately been making money not by timing the overall market but by propitious sector-selection. In contrast to 1991, when net asset values of short-selling partnerships fell by more than 30%, in counterpoint to the market's rise, shorts this year are in the right stocks at the right time. Short sellers have nimbly capitalized on declines in biotechnology, health care, real estate, and banking. "There has been some huge volatility in these stocks, and they've been cashing in," says Harry Strunk, a Palm Beach (Fla.) investment consultant who tracks short sellers.

RETICENCE. Despite their recent success, short sellers remain bloodied. Short partnerships are still feeling the effects of the 1991 massacre, which saw a dramatic change in the short-seller pecking order. Since the early '80s, the most visible short sellers have been the Feshbach brothers of Palo Alto, Calif. The Feshbachs' flagship partnership declined 56% in '91 and, Wall Street sources say, fell a further 0.3% through Sept. 30--making them one of the few shorts to sustain losses this year. With their holdings said to have fallen from nearly $1 billion in 1990 to $150 million, as investors fled, they have been supplanted as the nation's largest shorts by New York money manager James Chanos, who manages $550 million in short portfolios. Chanos and the Feshbachs declined to be interviewed for this story.

Such reticence is understandable: Nowadays, most short sellers work for nothing. They get the bulk of their income from performance fees, usually about 15% of profits. But most partnership agreements don't allow short-fund managers to draw fees until they've recouped any losses. Since short partnerships fell so sharply last year, the average fund must climb by an additional 25% before it can draw performance fees again. Thus, capital preservation is paramount. "For the most part, nobody got paid this year--it's still lean times. So they're a lot more gun-shy than they were in '91," says Mike Long, whose hedge fund, Rockbridge Partners, tracks and invests in short sellers. Market gains in October cut into short-seller profits, accentuating the need to reduce risk by diversification and less use of leverage.

But even though they have done well and are becoming more conservative, shorts are still coming up short at a longtime goal--attracting institutional investors. Pension funds and endowments remain wary of putting money into short funds. Some tested the short waters toward the end of 1990, but that was bad timing. "Every institution that went into short selling has lost money," notes Michael Murphy, a San Francisco short seller and editor of the Overpriced Stock Service newsletter.

HOT PICKS. Still, shorts are trying hard to make institutions more comfortable with bearish strategies. One money manager, New York's Leuthold Weeden & Associates, has createdan institution-oriented short portfolio of about 50 large-capitalization stocks, selected through 13 computer screens. "It has a bias toward stocks with $1 million in trading volume a day. That way, you don't have any problem with short squeezes," says John K. Holland, the firm's president. In a short squeeze, brokerages or investors make short sellers buy back the stocks they have borrowed, pushing up the price and hurting the shorts. Short squeezes are difficult to engineer in large-cap stocks.

Holland's fund made money by shorting large-cap pharmaceutical stocks such as U.S. Surgical and T2 Medical. General Motors Corp. was another well-timed pick. Likewise, Murphy also aims for big game. Although his newsletter strives to identify marginal small companies and scored big with ill-fated retailer Cascade International, Murphy's bread-and-butter picks are large-cap stocks. He recently covered short positions in major brokerages such as Salomon Inc. and Bear, Stearns & Co., and his recommendations are top-heavy with banks, such as Chase Manhattan Corp. and BankAmerica Corp. "I think a lot of people are shorting cyclical disappointments," observes Murphy. True. But if the market stages a postelection rally, shorts will have a long wait for their next paycheck.

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