GameStop, Sears may be profitable shorts

By thinking in terms of obsolescence, investors can make short selling work.

By Oct 3, 2012 12:22PM
Image Stocks circled in newspaper copyright Digital Vision Getty ImagesBy Chris Stuart 

As investors, we are taught from the beginning that in order to make money, we must buy a stock and watch it grow. How many times have we heard that XX dollars invested in Apple (AAPL) 10 years ago would have led to your early retirement?  

It's an easy idea for our brains to process -- especially if we follow in the steps of famous investors such as Peter Lynch, who once said that he would never invest in any idea he couldn't illustrate with a crayon.  

But short-selling, on the other hand, is often seen as a scary endeavor, especially for those who grew up thinking that buy and hold is the only way to put money to work. 

However, while not for everyone, shorting can be an extremely profitable venture. One way of thinking when looking for stocks to short revolves around "obsolescence."  As a refresher, I've copied the definition below:

Obsolescence is the state of being which occurs when an object, service, or practice is no longer wanted even though it may still be in good working order.

If we can think in terms of obsolescence, and use that same Peter Lynch methodology with the crayon -- or his other famous motto: "If you like the store, chances are you'll love the stock" -- we can increase our chances of identifying a profitable short.

Thinking in terms of obsolescence can be powerful yet difficult. It's not easy to envision what industry group or product might not exist in the next few years.

Looking back, had we predicted the demise of the physical book, the DVD, or the big-box electronics store, we could have made a fortune shorting the likes of Borders, Blockbuster, or Circuit City.

But how do we go about finding the next "obsolete" stock? 

It's not an easy task. But, if we think long and hard enough, it can be done. Use the Peter Lynch principles. Visit the mall. What stores or segments seem to have no traffic? What products in your life did you use in the past, yet no longer find the need to purchase -- due to something better taking its place and technological innovation (like the Amazon (AMZN) Kindle versus the book)?

We can get an idea of what the majority thinks by looking at the short interest levels.  Some of the most heavily shorted stocks are the ones expected to become obsolete in the near future. GameStop (GME), for example, is often compared to Blockbuster; the question -- can a retail brick-and-mortar video-game store survive in an age when a larger and larger percentage of video games are now downloaded to a console? Gamestop has done a good job of managing its situation, shifting into online gaming and turning many stores into Apple/Android (GOOG) tablet resellers. But it remains to be seen if the company can fight what appears to be a long-term shift away from its core business of physical video games.

Another heavily shorted stock which investors believe might someday become obsolete is Sears Holdings (SHLD). Sears, one of the early department store innovators, has become the dinosaur of the retail space as competitors such as Target (TGT) have provided a fresh and exciting shopping experience. As Sears works to sell off assets and cut down debt, the overall consensus is that it might be too late. 

So put on your Nostradamus hat and ask yourself: What might be the next stock to become obsolete?   

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