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The hardest thing to do in stock investing is to pick a loser. Think of how the odds are stacked against you. First, over the past 80 years, U.S. stocks have produced an average yearly return of a little more than 10%. Stocks make money (again, on average) in about three out of every four years. The period since 1994 is typical. Despite the tech-bubble bust, the 9/11 attacks, the 2001 recession, the war in Iraq and the subprime meltdown, Standard & Poor's 500-stock index, a good proxy for the U.S. market, rose in ten years and fell in three. The reason is simple: The economy grows an average of 5% to 6% annually, including inflation, and so do companies that take part in it.
Barely breathing
Second, and more important, finding a stock that is on the verge of a decline is extremely difficult. Because markets are awfully efficient, bad news about a company and its prospects is, in nearly all cases, already built into the price of the stock. For example, Ford Motor lost $5.63 per share for the 12 months ending June 30. That's for a stock that trades at about $8 per share. Yet Ford's price has risen over the past 12 months. Why? Ford may be in trouble, but its prospects seem to be improving.
An even better example, although farther afield, is the Baghdad stock market. Although the situation there may appear miserable on a here-and-now, absolute scale, investors see things improving on a future-focused, relative scale. James Grant wrote in his newsletter, Grant's Interest Rate Observer, in September, "The only thing stronger than the Iraqi currency is the Baghdad stock market." He added: "In January, just 41 listed Iraqi companies attracted any meaningful trading activity." But by the end of July, the figure had jumped to 58, and 42 of them were at all-time highs. In that month alone, the Baghdad market jumped 58% on a volume of 73 billion shares.
So even if you can identify a business (or a national market) that is rotten today, it's far from certain that you will be able to make money from your insight. The company does not merely have to be bad; the market must also think it will become worse.
In fact, the best way to begin a search for stocks that will decline is to look at what is popular, rather than what is out of favor. Each week, Value Line Investment Survey lists stocks with the highest price-earnings ratios -- based on the research firm's own method of calculating P/E, which includes both past earnings and projections.
At the end of September, when the market's P/E was 18, precious-metals stocks, such as Stillwater Mining and Agnico-Eagle Mines, had P/Es that exceeded 40. Meanwhile, mutual funds that specialize in natural resources were booming. For the year ending September 30, Van Eck Global Hard Assets returned 49%, and Fidelity Select Natural Resources, 53%.
Although a popular stock or sector must eventually come back to earth, there's no telling when the forces of gravity will apply the brakes. The price of builder Pulte Homes doubled between 1995 and 2000, doubled again between 2000 and 2001, and tripled between 2001 and 2005, eventually exceeding $40 a share. Since the start of 2006, however, Pulte has dropped to about $15.
Short selling
The way to make money with a stock that you believe will fall is to sell it short. That means borrowing the stock from someone who already owns it and promising to return the shares sometime in the future. You sell the stock today with the anticipation that you will be able to buy it back at a lower price later.
A popular strategy among professional investors, including many hedge-fund managers, is a long-short strategy that fits into a category called market neutral. Stock pickers find firms within a sector whose prospects are very different and invest on a relative basis. You buy the good stock (go long) and short the bad one (sell short). The amount you make depends on how much the stocks' performances diverge.
For instance, you might think that Motorola is a far better company than Nokia. You buy $10,000 worth of Motorola and short $10,000 worth of Nokia. If Motorola rises 20 percent and Nokia falls 10 percent, you make $3,000 (minus transaction costs). If both stocks fall but Motorola falls less, you also make money. Ditto if both stocks rise but Motorola rises more.
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