One big reason I’m avoiding these 10 stocks in 2020

Most great investors have a philosophy that can briefly be summarised as “take care of the downside and the upside will take care of itself.”

Warren Buffett has said: “I always start from a position of fear … I’m always looking at the downside on something first. I mean, if you can’t lose money, you’re going to make money.”

According to Buffett, “in terms of permanent loss, we’ve never – we’ve had plenty of losses, but they’ve never been the kind that really are destructive.” He reckons avoiding a permanent loss of capital on stocks is one reason he’s – in an understatement if ever there was one – “done reasonably well.”

Pays to be wary

Short-selling (or ‘shorting’) stocks is a risky business. If the stock goes to zero the maximum profit is 100%, but as stocks can rise by far more than 100% the loss for short-sellers who get it wrong can be huge – in theory, infinite.

Because it’s so risky, short-sellers – typically well-resourced hedge funds – have to be very confident indeed that they’ve found some serious flaw in a company’s business model or accounts. Many go to great lengths to confirm their suspicions – well beyond the inclination or resources of many ‘long’ analysts and private investors.

For example, a surreptitious visit to a company’s multi-million-pound property in the Bahamas may reveal it to be nothing more than a shack. A lengthy forensic examination of a decade’s acquisitions by a highly acquisitive company may reveal a failing underlying business. And so on.

Because of the depth of many short-sellers’ research, I think it pays to be extremely wary of the most heavily shorted stocks in the market. History suggests avoiding such stocks can save investors from some big underperformers and complete capital wipe-outs.

Stocks on my ‘avoid’ list

The table below shows the most heavily shorted stocks on the London market last Christmas Eve, and their performances up to the close of the market yesterday.

The average loss of the stocks was 11% over a period when the FTSE 100 gained 7%. Blanket avoidance of the 10 stocks may have meant missing out on Pets At Home’s short-seller-defying 109% rise, but it also meant dodging the bullet of the 100% wipe-out at Debenhams and 80% loss of value at Kier.

This is quite typical. The average loss of the previous year’s most heavily shorted stocks was 28% versus a 13% fall in the FTSE 100. Ocado was that year’s Pets At Home, with a 94% rise, but Carillion was a 100% wipe-out and Debenhams lost 89% of its value over the year.

Which stocks are on my ‘avoid’ list as we head towards 2020? The table below details the 10 companies currently sporting the highest interest among short-sellers.

For the most part, hedge funds don’t make their short theses public. However, for many of the stocks above I can see things that could form, or form part of, a short thesis. As such, I’m happy to avoid these stocks, and focus on companies I see as less problematic.