Identifying stocks with weak fundamental business fundamentals and avoiding investment in them is much easier.

In investment terms, “shorting stocks” refers to investing with the belief that the stock price will fall. On the surface, shorting seems like a fairly straightforward task for investors skilled in “going long,” where you invest with the belief that stock prices will rise—you simply do the opposite of what would be effective.

But upon closer observation, shorting stocks can be a very challenging way to invest in the stock market. About four years ago, in April 2020, I wrote “Why Shorting Stocks Is So Hard,” where I illustrated just how brutal shorting stocks can be using the story of Luckin Coffee:

At a gathering in June 2019, a distinguished and accomplished investor in our club gave a speech about Luckin Coffee (NASDAQ: LK)…

…During my club mate’s speech, Luckin Coffee’s stock price was around $20, roughly the same level as its closing price at its IPO in May 2019. He sold his Luckin Coffee stock in January 2020 when it peaked at $50. Today, Luckin Coffee’s stock price is around $4. On April 2, 2020, the coffee chain’s stock plummeted 76% in one day, continuing to fall before the stock was halted by the Nasdaq stock exchange operator…

…It wasn’t until April 2, 2020, that Luckin Coffee announced its board was conducting an internal investigation. Fraudulent transactions totaling approximately 2.2 billion yuan (around $300 million) were believed to have occurred from the second quarter of 2019 to the fourth quarter of 2019. According to Ycharts data, Luckin Coffee had revenue of $470 million for the 12 months ending September 30, 2019. The exact extent of the fraudulent transactions has yet to be finalized.

Luckin Coffee also stated that investors could no longer rely on its previous nine months’ financial statements ending September 30, 2019. The company’s COO, Jian Liu, was identified as the mastermind behind the misconduct. He has been suspended…

…It turns out, Luckin Coffee’s fraudulent transactions likely began as early as April 2019. From April 1, 2019, to January 31, 2020, Luckin Coffee’s stock price actually rose by 59%. It even surged by nearly 150% at one point.

If you had shorted Luckin Coffee’s stock as early as April 2019, even if your judgment about Luckin Coffee’s fraudulent activities was correct, you would have faced massive losses—exceeding your initial investment. This demonstrates just how difficult shorting stocks can be. Not only must your analysis of the business fundamentals be correct, but your timing must also be right because if you short, your losses could easily surpass what you own…

…The latest developments at Herbalife (NYSE: HLF) also illustrate the arduous task of shorting from another angle. Renowned investor Bill Ackman first disclosed his short position in Herbalife in December 2012. At that time, according to Herbalife’s 2011 annual report, the company was a “global network marketing company, selling weight management, nutritional supplements, energy, sports, and fitness products, and personal care products” in 79 countries. Today, according to Herbalife’s 2023 annual report description, Herbalife is a “global nutrition company offering health and wellness products to consumers in 95 markets.” Thus, the company has been engaged in nearly identical business during this period.

Ackman’s thesis centered on his view that Herbalife was operating a pyramid scheme, making its business model fundamentally unsustainable. When Ackman announced his short position in Herbalife’s stock, the company reported continued strong growth in its business. From 2006 to 2011, Herbalife’s revenue compounded annually at 13%, increasing from $1.9 billion to $3.5 billion, while profits rose from $143 million to $415 million, with a compounded annual growth rate of 24%.

Although Herbalife has never been formally found to operate an illegal pyramid scheme, its operational performance has been poor since Ackman publicly disclosed his short position. The table below shows Herbalife’s revenue, net income, and net profit margin from 2011 to 2023. It is noteworthy that Herbalife’s net income and net profit margin have shown a significant downward trend during this period.

According to a Bloomberg article published at the end of February 2018, at the time of printing the article, Ackman had actually closed out his short position in Herbalife. I believe most investors who speculated on the returns of Ackman’s short position in Herbalife merely by examining the company’s financial trajectory from 2011 to 2017 would have noticed a significant deterioration in the company’s net income—a nearly 40% decrease—and net profit margin, which dropped nearly 40%, from 12.0% to 4.8%, and concluded that Ackman might have made a decent profit…

…But the market had a different idea. On the day before Ackman first publicly announced his short position, Herbalife’s stock closed at $23.16. By the time the aforementioned Bloomberg article was published, its closing price was $46.05, double the $23.16. Since December 2012, Herbalife’s highest closing price was $61.47, reached on February 4, 2019. Currently, Herbalife’s stock is at $8.07. Prior to Herbalife’s announcement of its fourth-quarter 2023 results, its stock price fell 32% to $8.03 on February 15, 2024. After the significant drop, Ackman tweeted, “A very good day for my psychological short in Herbalife.”

The market eventually reflected Herbalife’s deteriorating fundamentals, but the mid-term journey was a wild ride. Similar to Luckin Coffee (borrowing from the closing passage of “Why Shorting Stocks Is So Hard” above), if you had shorted Herbalife’s stock as early as December 2012 and held that position until now, even if your prediction of Herbalife’s fundamental breakdown and eventual stock price decline was correct, you would have faced significant losses during the transition period—more than what you invested…

…Investment sage Philip Fisher once wrote, “The stock market is filled with individuals who know the price of everything, but the value of nothing.” This explains why shorting stocks is hard—really hard. To succeed in shorting, you need to correctly interpret the fundamental business fundamentals of stocks and the timing of stock price movements. In contrast, identifying stocks with weak fundamental business fundamentals and avoiding investment in them is much easier.