Short selling: useful tells of a company in trouble
Short selling is a symptom of a troubled company, rather than the cause. Evidence suggests that defensive measures made by firms against short sellers provide a good indication of future negative returns.
In this blog post we look at how short selling works, explore the common misconceptions around the art of betting against a company and why a conflict between company executives and short sellers is a good indication that something more sinister may be going on.
What is short selling?
Short selling, or shorting, is when an investor profits from falling share prices. To short a stock, the short seller first needs to find someone who owns the stock and is willing to lend it. When in possession of the stock, the short seller then sells the stock in the market to a buyer at the current market price.
At a later date, the short seller must repurchase the stock and return it to the lender. If the share price has fallen over this time, the short seller makes a profit. But if the share price has rises, they will have made a loss.
In practice, obtaining a stock to short is a lot easier than the underlying mechanics described above suggests. Investors can enter into a short position using a broker who facilitates the stock borrowing process, making it as effortless as going long a stock.
When shorting, there is a cost for borrowing shares which is usually expressed as a percentage of the value of the shares. It is worth remembering, though, that at times brokers may not be able to find shares to borrow if there are no investors willing to lend out their stock. Short selling without borrowing is known as a naked short and is banned in most developed countries.
Why are short sellers viewed with suspicion?
Famous investors who make their money from buying under-priced companies tend to be celebrated as heroes by the investing community. For instance, legendary value investor Warren Buffett is commonly referred to as the 'Oracle of Omaha', while the late Sir John Templeton - whose Templeton Growth Fund averaged 16% per year between 1954 and 1999 – is known as the greatest global stock picker of all time.
However, such affections tend to not be extended to successful short sellers, who instead are often often blamed for either causing or aggravating a market sell-off to reap bigger returns. The current most hotly contested battle between short sellers and management is on Tesla stock (TSLA). A twitter search for $TSLA or $TSLAQ will expose two communities arguing whether Tesla will become the eventual the winner of a rapidly growing electric vehicle market, or instead, struggle to reach profitability and continue to haemorrhage cash.
Tesla chief executive officer (CEO), Elon Musk, has frequently criticised short sellers, labelling them 'value destroyers' and even said that short selling should be made illegal. Earlier in the year, Tesla’s share price had been under severe pressure from short sellers, falling as much as 46% since the start of 2019 and 54% since the previous high in September 2017.
Figure 1: Tesla share price drawdown
The share price has since recovered some of these losses but has underperformed iShares Electric Vehicle & Driving Technology ETF (ECAR) by 7.4% since the exchange traded fund (ETF) was launched in February 2019. ECAR provides investors with diversification across 99 different electric vehicle-orientated companies and holds just a 1.27% weight in Tesla. Unless you have a strong conviction on a single stock, it is wise to diversify across a growing industry to help lower your risk and benefit from the eventual winners in the industry.
Another contributing factor to the culture of short seller suspicion is how shorting has been banned by regulators during times of financial distress to try to shore up falling markets. It is quite obvious that any activity or product that gets banned by a regulator, even temporarily, is more likely to be perceived by the public as exhibiting negative externalities.
During the 2008 financial crisis, regulators in the US, UK, Germany and Japan all restricted short selling. But the view that short sellers cause or aggravate market sell-offs is a misconception. A paper by the Federal Reserve Bank of New York analysed the impact of the short ban that was implemented by the U.S. Securities & Exchange Commission (SEC) in the wake of the 2008 financial crisis and found little evidence to suggest that short selling was the cause of the stock market crash or that the ban had any success in slowing the decline in stock prices.1 It seems that short selling is a symptom of a falling market or failing company, rather than the cause.
Even so, more recently the Chinese regulator blamed short sellers for exasperating the 2015 China stock market crash, reportedly arresting 200 people for allegedly 'spreading fake information on securities and futures market'.
Why is short selling important for efficient markets?
But although short sellers get a bad rap, short selling provides financial markets with multiple benefits. The first is price discovery as it helps to ensure markets are efficiently priced, which in turn drives a more rational allocation of capital. Shorts may target a company whose operations are no longer economically feasible. If successful, this frees up resources from the so-called zombie firm to be deployed in a more profitable area of the economy.
The second benefit is through increased market liquidity. Studies have shown that restrictions on short selling typically lead to reduced trading volumes. According to latest available estimates - a quarter of all trading on the US stock market is by short sellers, with hedge funds executing the lion’s share of these trades. While this figure is from 2009 and may have changed over the last ten years, it highlights how integral short selling is to financial markets.
Reduced liquidity from restricted short selling also leads to a significant widening of spreads, which ultimately results in increased costs for investors. A study of the 2008 financial crisis showed that the spread on stocks with a short ban increased by 150% more than on stocks without such restrictions.2
Figure 2: Daily time-weighted average spreads
The third benefit that short activists bring to financial markets is an intense scrutiny of a company’s financial statements, operating model and future prospects. The uncovering of any sensitive information is highly beneficial as it allows investors them to better assess their investment hypothesis. However, uncovering overvalued companies is a tricky business. Finding short targets takes an advanced level of knowledge and experience.
Top 3 characteristics for short candidates
- Obsolete business models
The most obvious angle that shorts can take is if they believe the target’s product is no longer relevant. A new or improved version from a competitor will reduce the demand for the firm’s product. Timing is a key consideration here
- Accounting irregularities
A short activist may seek to uncover accounting issues. From creative accounting methods to outright fraud. A company which engages in aggressive earnings management may struggle to keep up the act over the long term, ultimately resulting in reputational damage at best, or at worst, a restatement of earnings which will have a large, negative impact on its share price
- Poor management
A short seller should question how well the company is being run. Are costs under control? Are management paying over-the-odds for acquisitions? This all ties in closely with accounting choices. Poor decision making increases the risk of accounting foul-play. A short may also check the track record of management in previous positions at other firms
How do firms defend themselves from short sellers?
A company can choose to overlook the short sellers’ accusations or defend their share price through anti-shorting actions. The most common method is verbal retaliation, which can be achieved through an official press statement, a media interview or by taking to social media (see Elon Musk’s Twitter account).
In February 2016, a previously unknown research outfit called Zatarra Reseach alleged in a report that German payments provider Wirecard (WDI) was engaged in financial fraud. Wirecard’s response: 'Everything is based on insinuations and false conclusions that are obscured by the complexity of the allegations'. WDI initially fell 30%, but has since steamrolled higher, outperforming the German DAX index by over 200%. In this case, it appears the shorts profited initially, but long-term short seller will have lost a huge amount of their capital.
Another action to defend the company is to threaten legal action. This seeks to prevent outspoken shorts from encouraging other investors to short the stock.
Aside from the verbal threats, companies can also take more technical forms of action to dissuade investors from shorting their stock. For instance, a firm could ask existing shareholders to withdraw their shares from the stock lending market, leading to a loan recall of the stock. This increases the cost and difficulty of obtaining borrow for the stock, and also increases the risk that existing short positions are closed involuntarily due a recall of the loaned stock.
No smoke without fire
However, the effectiveness of these defensive actions appears to be limited with research showing that anti-shorting actions by firms are in fact a good indicator of negative future share price returns.
A paper published in the National Bureau of Economic Research found that firms who take anti-shorting actions return 2.34% less than the market per month, over the 12 months after the action taken by the firm.3
It therefore appears the expression 'no smoke without fire' can generally be applied to firms targeted by short activists. One short seller referenced in the paper said, 'the louder the shout, the better the short', implying the greater the efforts of the firm to defend their share price, the greater the profit potential.
Shorting is not an easy game
In practice, shorting stocks is difficult. Whether it is uncovering fraud or convincing the market that a business is in decline, you may indeed be correct, but it may take a very long time to convince other investors of your revelation. Costs such as stock lending charges can eat into your returns, so timing the trade is incredibly important. As John Maynard Keynes said 'markets can remain irrational longer than you can remain solvent' certainly rings true for short selling.