<p>I was talking to a friend of mine, and he said something about playing the stock market, and he says that his strategy is shorting companies that are over-valued. I say, how could you know that? He explains to me about the financials , and that some have high market capitalization that isn’t justified by revenues.</p>
<p>Now that got me thinking, why doesn’t the SEC limit the market cap for companies that have poor balance sheet? Why can’t they stop companies from issuing more shares? Doesn’t companies have to register those shares before they can issue that to the open market or even private sale of equity? </p>
<p>Maybe set a limit like 4 times the revenue. So, if a small company has $20,000 dollars in revenue, they should not a billion dollar market cap. </p>
<p>4 times revenues? Say goodbye to the markets.</p>
<p>First off, I think you don’t understand the concept of investing well enough to even try to understanding shorting (which is a whole different ball game in itself - ask Bill Ackman).</p>
<p>Secondly, why wouldn’t a company try and raise more capital if it had a poor balance sheet? You have to spend money to make money and if you don’t have any money, you are either forced to close shop or acquire funds via equity sales or notes. </p>
<p>Finally, the reason they are estimated valuations is due to a numerous amount of items, including things you already know (like past performance) and things you expect (like future earnings and growth potential). Stock pricing isn’t simply done on a basis of revenues. There are a lot of intangibleas and grey-area for the future expectations of a company that are built into the stock price. </p>
<p>If you want to get into the market, your best bet is to just put money into your 401k and have some fund manager do it for you. </p>
<p>Oh and for what it’s worth, basic theory shows that you can have limited losses and unlimited gains with going long (AKA buying) a stock but you can have the opposite with a short position.</p>
<p>OP - Don’t even think about doing this. Instead, research instances where micro-cap companies get a spectacular bit of news and their stock price quintuples overnight. Calculate how much you’d have lost if you’d shorted them. Basically, you don’t want to be on the wrong side of that trade! Oil, precious metal and pharmaceutical companies are good places to look for these types of instances.</p>
<p>PS, In fairness you can also do very well if you develop a good sense for “pump and dump” schemes, presuming your broker can find someone willing to lend stock for shorting. (Check out the 3-year stock price chart for GUNP.)</p>
<p>Short-selling is an interesting game. You can do well and then blow up. Why? Let’s say the price goes up. You have to cover by delivering the stock. Responsible short-sellers have the stock - either they own or borrow the shares - and then make a bet the stock will move south. But naked shorting is common and that means coming up with stock that may not even be available. Naked shorting is the problem regulators often attack because it can destabilize markets when people can’t come up with the shares. The process of short-selling in general though is how markets work: someone makes a bet up or down, a price is paid, someone wins. A short seller will typically pay a fee to borrow shares, etc. This all gets very complicated, but what most people mean when they say someone is “short selling” is naked shorting.</p>
<p>In some cases, markets have been bluntly manipulated by gangs of short-sellers driving down the stock price. This is a real problem with lower priced stocks on certain exchanges. (BTW, there is a shorting effort underway now with Herbalife; there are accusations being made the thing is more a pyramid scheme than a multi-level marketer. Shorting can involve revealing truths.)</p>
<p>There is an underground of shorters who have made fortunes attacking developing country stocks. I know of some Chinese traders who go through Chinese company financials to find fraud. I know of a kid who made tens of millions in grad school. That kind of story is what attracts people to the game. BTW, Chinese financials are in Chinese so fluency is required.</p>
<p>I sort of understand how short selling works. Obviously, it would not be wise to short immediately after the run just started. Better to wait for the hype to weakens, or volume to decline. </p>
<p>I ask this question because I thought that maybe if the SEC is more strict or did something like an automatic halt to small companies with hardly any assets, but has pps that has risen tremendously, then maybe this will lessen the pump and dump schemes…</p>
<p>I’m surprised how many scam companies are listed on NASDAQ!!</p>
<p>While it is not widely understood, the securities laws were written on the back of a decision regarding what kind of regulation would be “best”. There are two basic types.</p>
<ol>
<li><p>Merit regulation, which means that regulators would decide what securites could be traded, and could block investment in companies that they thought were “meritless” investments. </p></li>
<li><p>Disclosure regulation, which means that it would be legal to sell highly speculative, management and founder-biased deals, as long as everything was properly disclosed.</p></li>
</ol>
<p>With some exceptions at the fringes, we have disclosure regulation. There is nothing to stop markets from bidding up companies to levels that rational people think are crazy. There is nothing to stop stupid people from paying too much for a stock. [Short sellers can put a lid on such a stock, but it is risky to do. There is a large supply of not-so-smart money out there, and there is also an active trading community that delights in attempting “short-squeeze” trades.]</p>
<p>There are some protections in the various “acts” (regulations) which serve to protect smaller investors, based on the idea that they are more likely to be ignorant. Investments which are sold only to rich people are often exempt from these regulations, on the premise that rich people can look out for themselves.</p>
<p>The idea of the government controlling prices seems interesting, until brains become fully engaged, and one realizes that if it were possible to control the prices of things with impunity, then logically we should simply control the price of everything and be done with it. Everybody wishes econ 101 could be repealed, but it can’t.</p>