Learn The Rules: Shorting Dividend Stocks Can Be A Costly Mistake by Brad Thomas

Summary

High-quality dividend stocks that are overvalued can remain overvalued for long periods of time.
Tanger is an example of an "obviously" great short that wasn't.
Even shoddy companies can cost shorts money.
This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

This article was co-produced with Dividend Sensei and edited by Brad Thomas.

Over the last several years, I have witnessed folks shorting REITs. It never ceases to amaze me that these so-called market timers believe that the fastest way to achieve the highest returns is by making short-term trades that are accurately timed.

I have lived long enough to know that there is absolutely no way to accurately and consistently time short-term market movements, unless you have a crystal ball that is.

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In this article (along with Dividend Sensei), I plan to explain in detail why shorting stocks is a speculative strategy. As value investors, we recognize that fundamental analysis is the closest thing we have to a crystal ball – and shorting stocks is tough to pull off because it's inherently a short-term strategy that is high cost (when done with dividend stocks) and requires you to be right about

the timing of a stock's short-term price action
the magnitude of price changes
when the price will reverse (go up)

We want to offer three examples of why this can be a costly mistake, with a poor reward-risk ratio. This goes not just for quality stocks that are overvalued, but even for low-quality names that might indeed end up going to zero eventually.

Example 1: Quality Dividend Stocks That Are Overvalued Can Remain Overvalued For Long Periods Of Time

Shorting a stock means borrowing shares from your broker, selling them and then buying them back, hopefully at a much lower price. You pocket the difference minus interest your broker charges and dividend payments which you are liable for.

In theory, a stock in a bubble is a great short candidate. The trouble is that as famous economist John Maynard Keynes said:

Markets can remain irrational longer than you can remain solvent.

Our experience as analysts has taught us that usually high-quality dividend stocks (including REITs) can cycle between 33% overvalued to 33% undervalued. But "usually" isn't "always", and here is a great example of a high-quality dividend-growth stock that got into a bubble and just kept going up.

(Source: F.A.S.T. Graphs, FactSet Research)

Over the past 10 years, Super SWAN dividend king American States Water (NYSE:AWR) has averaged a 22.7 PE, which is artificially high due to its current bubble.

If you had used 33% overvaluation, the purple line in the chart, then you would have shorted AWR at $55.72 in April 2018, confident that it would soon correct to more historical levels ($41.33 would have been approximate fair value).

That would have netted you $14.4 per share, minus about 2% to 3% annual broker interest and a 1.9% dividend. In other words, your pre-tax profit, had AWR fallen to fair value within a year, would have been about 20%, or 16% after taxes.

It seems like a pretty decent potential return, right?

Look what actually happened. AWR went parabolic, driven by "utilities are bond alternatives" frenzied buying. The stock is up 62%, or $35 per share. On top of that, the company paid out 3% worth of dividends, meaning you're now 65% underwater.

Anyone who shorted AWR when it was obviously overvalued likely has gotten at least one if not several margin calls by now, requiring they put up new money to keep the trade alive.

With REITs, the cost of shorting can be very high since the sector is known for its rich yields.

(Source: F.A.S.T. Graphs, FactSet Research)

Here's Realty Income (NYSE:O), which is clearly overvalued. The purple line represents a 24.9 P/FFO, meaning it is 33% historically overvalued, and a multiple the REIT has achieved just once before suffering a bear market.

But before you run out convinced that Realty Income is a great short from that level (price of $82), keep in mind that Moody's Analytics just put out a report that US 10-year yields might fall to as low as 0.5% in the coming years.

Granted, that would require a recession, which would likely significantly send down Realty Income, like all stocks. But the current economic fundamentals indicate that the US economy is still growing about 1.4%, and that 12-month recession risk is 39% (61% probability of no recession).

If US Treasury yields were to fall to record-low levels, there is literally no telling how high Realty Income might fly in the short term. Before we saw American States hit a PE of almost 50, we would have thought such a thing impossible.

Could Realty Income hit a P/FFO of 30? 35? 40?

You should never underestimate the madness of the market in the short term. Shorting means a limited upside but potentially unlimited downside, creating the opposite reward-risk ratio for owning stocks, unlimited upside vs. limited downside.

...Originally Posted On Seeking Alpha

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