Short selling, the tactic of selling a borrowed security in the
hopes it can be bought back later at a lower price to repay the
loan, falls broadly into two categories. In one the short seller
suspects or alleges a fraud or misrepresentation, while in the other
the trade is based on the belief that the stock is over-valued and
Jim Chanos’ highly lucrative short of the Byzantine fraud at Enron
in 2000 and 2001 is perhaps the archetype of the first school, a
speculation with a more than satisfactory ending for him as the
stock tumbled from the high double digits into bankruptcy protection
as accounting chicanery came to light. The dotcom bubble offers many
examples of the valuation type of shorting opportunity, companies
that were as honest as the day is long but possessed of suicidal
business plans and ultimately dependent on the discovery of a series
of greater fools to supply the needed capital to fund the burn rate.
Those short sales of mortgage-backed securities during the last
financial crisis might be considered a hybrid, combining as they did
a certain amount of fraud in the mortgage process with an unhealthy
dose of silly valuations of real estate and derived securities.
Wall Street wisdom on these two schools is that identifying fraud
pays better than bubble-pricking stocks with crazy valuations, a
belief pithily expressed in April by famed short-seller David
Einhorn of Greenlight Capital.
“We have repeatedly noted that it is dangerous to short stocks that
have disconnected from traditional valuation methods,” Einhorn said
while discussing a basket of shorts of unnamed momentum stocks he’d
“After all, twice a silly price is not twice as silly; it’s still
It looks as if that prejudice may be grounded in reality, according
to Alon Bochman, managing partner of Stepwise Capital, who has done
us all a favor by looking at numbers from Activist Shorts Research
(http://www.activistshorts.com/), a service tracking activist short
“It seems the poor reputation valuation shorts have is at least
partially deserved. Even when we look at some of the best known and
most memorable short campaigns of the past decade, valuation shorts
significantly underperform fraud shorts,” Bochman wrote for the CFA
THE VALUE OF OBLITERATION
The data set includes more than 400 short-selling campaigns from
2002 to the present, though the definition of the length of a
campaign is necessarily nebulous. The mean return (not including
dividends) of stocks in the sample is negative 14.2 percent, with 65
percent of the campaigns resulting in some drop in the stock price.
In a key 4 percent of campaigns, the stock price dropped by 99
percent or more.
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Activists Shorts assigns a primary allegation to each campaign,
allowing Bochman to put them into two buckets, those mostly about
alleged fraud and those mostly about valuation. The return divide is
clear: among 229 fraud-based campaigns we saw a mean return of
negative 30 percent, while among the 219 valuation-driven campaigns
the mean return was positive 3 percent.
To be clear, we need to be
cautious about this data. It is not guaranteed to be exhaustive, and
the results we are looking at are simple stock moves. While you can
extrapolate that it's easier to make money shorting a stock that
falls by a third compared to one which rises by a few points, this
takes no account of the costs of the enterprise, not to mention the
sorts of time values that might eventually lead to a big gain if you
are patient and deep-pocketed enough.
The key, of course, is in the distribution of those returns. Fraud
allegations included the vast majority of the cases which resulted
in a near or complete obliteration of the target’s stock value.
also may be that the past 12 years have simply included quite a few
terrible times to short stocks on a valuation basis. While the
financial crisis would have burst quite a few bubbles, it is
important to remember that anyone shorting anything since 2009 has
been effectively spitting into a mighty wind being blown by the
Federal Reserve in the form of its monetary policy.
A shakeout in social media and new energy stocks may eventually
arrive, if ever the Fed is able to tighten, and may do quite a bit
to change these numbers.
Still, the wise might find better results looking for the next Enron
rather than the next Pets.com.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be an
owner indirectly as an investor in a fund. You can email him at
email@example.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by James Dalgleish)
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