“One painful lesson on the short side has been that mere absurd overvaluation is not sufficient reason to be short.” -Whitney Tilson
In The Big Short, Michael Lewis outlined the experience of a handful of investors who saw the red flags before the onset of the 2007-08 financial crisis and were determined to find ways to profit from the collapse. In hindsight, the housing downfall and credit crisis seem like glaringly obvious missed opportunities for many others to have taken advantage of. However, the part of Lewis’s book that has stuck with me was how incredibly arduous it was for investors like Steve Eisman and Michael Burry (some of the main real-life characters of the story) to successfully short the housing bubble, even though they virtually knew its demise was inevitable.
For those who understood ahead of time the pending doomsday scenario that was already set in motion by excessive leverage and highly questionable risk calculations by banks, the “Big Short” trade took far longer than expected to play out. Eisman, Burry, and others who profited from the downturn had to continue to secure funding/leverage, fend off unhappy clients, and endure significant emotional strain to keep their exposures in place until the tide finally turned in their favor. More succinctly, Lewis’s in-depth recap of the pre-crisis journey is a powerful illustration that shorting ain’t easy – especially when you’re trying to short the collapse of the financial system itself. That is at least one aspect of what Mr. Tilson alludes to in today’s quote.
The meme stock phenomenon, which made for many salacious headlines earlier this year, once again brought short-selling into the limelight. The power of social media and retail-investor crowds were harnessed as a way to “stick it to the man” via a combination of Reddit and Robinhood, squeezing short-sellers out of their positions (with “the man” in this case being hedge funds trying to profit from the collapse of some struggling companies). More quietly, however, shorting stocks is a standard part of everyday financial markets and generally goes unnoticed by most investors.
Recently, a client inquired about the effects of investors shorting a given small-cap stock – particularly one that he believes to be a good business at its core. Should business fundamentals ultimately win out, or are common stock shareholders (aka “the longs”) at the mercy of “the shorts,” barring a coordinated effort ala Robinhood/meme situation to drive out the short interest? Frankly, I don’t know enough about the subject to provide a robust off-the-cuff answer, so my goal today is to research this topic and see where that leads us.
Instead of buying a stock with the goal that the share price goes up (aka being “long” the stock), short selling involves selling a stock (without ever having owned it) to try and benefit from the share price declining (aka being “short” the stock). Mechanically speaking, one has to borrow the stock and then sell the shares into the market (to buyers) to establish the short position. Trading platforms (or, more accurately, broker-dealers, or “B-Ds”) facilitate the lending of the stock using a margin account, and they charge interest to do it.
Like buying a stock, shorting a stock is simply a way to express a perspective on the price movement of a company’s share price. There is a vital difference, however. With a long position, you can only lose the amount you’ve invested because the downside price stops at zero. At the same time, your gains are theoretically unlimited since there is no upper bound on how high a stock price can climb. With a short position, it’s just the opposite: losses are theoretically limitless (like Bradley Cooper), so shorting is by no means for the average investor. And given that two primary uses of shorting are speculation (hoping the share price goes down) and hedging (attempting to offset some other portfolio risk, concisely), that makes perfect sense, as speculation and hedging simply aren’t needs of average investors.
To close out a long position, the shares have to be sold. To close out a short position, on the other hand, the shares must be repurchased and returned to the lender. If a short seller has made a bad trade – where the stock goes up in value and creates mounting losses – the position may also be closed for the investor by the B-D, leaving them with the resulting losses and margin-interest charges. Flipping back to The Big Short story momentarily, these are reasons why it can be challenging to keep short positions in place for an extended period. If the trade initially goes against you, margin calls may require additional collateral to be posted. There is also an interest expense along the way for whatever borrowing/leverage is needed to create the trade. If the situation becomes unsustainable, then positions will be closed out, and it’s “game over” with potentially catastrophic realized losses. It’s FAR different than just holding onto a long stock position through a downturn until it recovers.
A Shortie but a Goodie
According to Investopedia and other research, there are several reasons why short selling is thought to be a positive element of equity markets; these include better price discovery (exposing overvaluation or poor business practices of companies), enhancing market liquidity, and increasing income (to the longs from whom shares are borrowed). The practice of shorting can also be detrimental (and illegal) if it crosses the line into the practice of “short & distort” – shorting a stock and combining this with a smear campaign in an attempt to decimate the share price (essentially the opposite of a pump-and-dump scheme).
Float Your Boat
In financial jargon, the “float” refers to the number of outstanding shares of a company (i.e., “shares that are publicly owned and available for trading”).
What About the Question at Hand?
So, does short-selling negatively impact stock prices? The answer is seemingly both yes and no, depending on timeframe and specific circumstances, so let’s consider some additional factors:
The Float: In financial jargon, the “float” refers to the number of “shares outstanding” of a company (i.e., “shares that are publicly owned and available for trading”).
Liquidity and Volume: All else being equal, a larger float can mean more liquidity, but it also largely depends on trading activity. Thus, a better measure to provide a clearer sense of liquidity is average daily volume – or how many shares are traded per day, on average, usually over the last 30 days.
Short Interest: “is the total number of shares of a particular stock that have been sold short by investors, but have not yet been covered or closed out” (source: Investopedia). Short interest can be expressed as a number (e.g., 100,000 shares of company A’s stock have been sold short), but is perhaps more usefully described as a percentage of the float (e.g., 5% of company A’s stock has been sold short). At least one article is clear in citing a ratio below 10% as normal (positive sentiment), above 10% is “fairly high” (pessimistic sentiment), and about 20% is exceptionally high.
Short-Interest Ratio: Combining the above, what may matter even more is the short interest compared to the stock’s liquidity. For this, we use the short-interest ratio or “days-to-cover” ratio. Just like it sounds, it’s calculated by dividing the short interest by average daily volume. That lets us know how many days, on average, it would take for all short positions to be covered. Taking in several opinions and spot-checking stock quotes of some of the companies we hold for clients (via FactSet), a days-to-cover ratio in the low single digits (e.g., 1-3 days) seems pretty normal.
The Short Squeeze: Higher short interest in a stock can indicate increased negative sentiment about the company. However, some investors may see a very high short-interest ratio as a buying opportunity, especially if the stock price has recently declined. Why? Well, if the stock price starts moving against the shorts (i.e., higher), they may have to quickly cover their positions to lock in gains or avoid losses. If liquidity is limited (e.g., there is a high days-to-cover ratio), the shorts will have to repurchase the stock at higher and higher prices. This phenomenon can happen very rapidly (as it did with the meme stocks) and is known as a “short squeeze.” It’s essentially the opposite of what happens in a market selloff, when investors sell at lower and lower prices to unload their positions.
Putting it all Together
I think it’s fair to say that short selling can affect a stock price in the short term or even be a catalyst for a more dramatic unwinding of an overvalued stock with serious underlying issues (e.g., fraud that has yet to be broadly exposed). However, it requires a significant level of short interest and concerted effort. Normal levels of short interest for a fundamentally strong company should have a minimal long-term impact. Short sellers may be able to trade along with share-price pullbacks from time to time, but they’ll have to take gains or else realize losses as the stock price ultimately moves against them (appreciates) in upward trends. We know that viable businesses generating legitimate earnings tend to be rewarded in the form of higher share prices over the long term. And, with that in mind – if liquidity and short interest measures are reasonable for a given stock – my conclusion is that the (little) shorts aren’t to blame for lack of share-price appreciation over any meaningful length of time.
Until next time, this is the end of alt.Blend.
Thanks for reading,