If short you must, look for fraud

[October 02, 2014] By James Saft

(Reuters) - (James Saft is a Reuters columnist. The opinions expressed are his own)
If you want to cash in as a short-seller, better to do some forensic accounting rather than looking for silly valuations.

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 will fall.

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 undertaken.

“After all, twice a silly price is not twice as silly; it’s still just silly.”

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 sellers.

“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 Institute. (http://blogs.cfainstitute.org/investor/2014/09/29/do-valuation-shorts-work/)

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.

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.

It 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 [e-mail] and find more columns at http://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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