Go Down Fighting: Short Sellers vs. Firms (2012)
Owen A. Lamont
The Review of Asset Pricing Studies 2(1), URL
I like controversial and (in my opinion) misunderstood topics. After covering High Frequency Trading and ESG, this week’s AGNOSTIC Paper examines the next big one: short selling. The paper is unfortunately already more than 10 years old, but it is still a go-to reference for short selling. Apart from that, the fights between firms and short sellers are also quite entertaining – at least from an outsider’s perspective…
Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.
Setup and Idea
Short sellers bet on falling prices. This gives them a very important role in markets. They are the skeptics, correct overvaluations, impose discipline on companies and have a good track-record in uncovering fraud. They also protect less sophisticated investors (who are willing to believe them) from losses. Despite those desirable virtues, many people don’t like short sellers. They profit when firms collapse or undergo severe restructuring and some believe that it’s morally wrong to make money from other people’s pain.
While understandable, this is (in my and the literature’s opinion) still misleading and not the full picture. In aggregate (not all of them!), short sellers do more good than harm. Yes, they profit from collapses of badly run companies and frauds. But they can only do that when badly run companies and frauds exist. The public debate should therefore focus on the companies that cause the mess rather than the short sellers who clean it up. Who is more evil? The management of Wirecard who scammed thousands of investors and other stakeholders or the short sellers who uncovered the fraud and made some profits from their positions? In my opinion, the answer is clear…
Before we go into the paper, a brief comment on the mechanics of short selling. “Shorting” an asset is more difficult and more risky than buying it. In practice, short sellers typically borrow shares, sell them in the market, and attempt to repurchase them at a lower price later. After repurchasing, they hand the shares back to the lender and the short transaction is covered. An example: If short sellers sell borrowed shares today at 100 and repurchase them at 80 in two months, they made a pre-cost profit of 20. But borrowing shares is of course not free. The securities lending market determines the borrowing fee depending on the current short interest of the particular asset. A perverse feature of this market is the fact that the most obvious shorts are often too expensive to implement. The saying therefore goes that short selling always works, except when you want to do it.
In addition to borrowing fees, short sellers also face other problems long-only investors don’t have. First, there is an asymmetric risk-return profile. If you buy a stock, your upside is practically unlimited while your downside is capped at -100%. If you short it, that pattern naturally reverses. The best possible outcome is a collapse to zero while the downside is practically unlimited. If you short a stock at 100 and it quadruples to 400, you lost 300 on a 100 initial investment because you must deliver your borrowed shares back to the lender. Buying a stock is an option, shorting it is a liability.
Second, regulators sometimes prohibit short-selling to keep things calm. For example, the SEC prohibited short-selling of US bank stocks during the financial crisis and the German BaFin (falsely) prohibited short-selling in Wirecard before the collapse in 2020.
Third, you don’t have a lot of friends. Short sellers are something like the police of financial markets and thus, management teams (of fraudulent companies) don’t like them.
On the other hand, a profitable short strategy is very valuable to investors and justifies high fees for the manager. If you have the skill to make money from falling stock prices, you will most likely be negatively correlated with stock markets over the long-term. Adding a profitable short strategy to a long-only portfolio should therefore produce better risk-adjusted returns over the long term. This is the main reason why institutional investors invest in such strategies.
Data and Methodology
As it turns out, firms that get in the sight of short sellers don’t just accept their fate. They typically Go Down Fighting and try to make the life of short sellers as difficult as possible. For example, they sue them, accuse them of crimes, ask the regulators to investigate them, and sometimes even threat them. Firms also take technical actions to engineer short sale constraints. For example, they can ask existing shareholders to withdraw their shares from the securities lending market which makes short selling more costly. Sometimes, they even issue a new share class. The goal is always the same, make the life of “evil” short sellers more difficult.
From the perspective of an efficient market with “correct” prices, this is all bad. In an ideal world, you want to have well-informed short sellers who can easily capitalize on their insights by betting against overvalued companies. So short sell constraints are frictions that could lead to prolonged overvaluation in markets.
The author of this week’s paper tests this hypothesis and hand-collects a sample of battles between short sellers and firms in the US market. He uses several news databases (LexisNexis, Dow Jones Interactive) to identify 327 short-sale events from 266 unique firms between March 1977 and May 2002. He also groups the reactions of the shorted firms into nine categories and the following table summarizes the sample.
As you can see from the chart, management teams get quite creative to defend themselves from short sellers. My personal favorite is “CEO sets up system to buy own stock” and the author indeed explains there were two cases where CEOs bet against short sellers with their own money.
To analyze the performance of shorted companies and to examine the overvaluation hypothesis, the author matches stock returns from CRSP to his short-sale events. He also explains that companies in his sample tend to be larger growth companies with high trading volume and (unsurprisingly) high short interest.
Important Results and Takeaways
Short-seller-fighting firms tend to massively underperform
The key result of the paper are the returns of short-seller-fighting firms over the months and years after the battle. The following table shows excess returns with respect to the CRSP value-weighted index (market-adjusted) for each of the categories.
Short-seller-fighting firms significantly underperformed the US market over the following 3, 12, and 36 months. On average, monthly returns are astonishing 2.58%, 2.34%, and 1.48% lower than for the overall market, respectively. This is substantial. A monthly loss of 2.34% compounds to about -25% over one year. There is considerable variation between the different categories, but the overall pattern remains very stable and there is no case where short-seller-fighting firms outperform the market.
The practical implications are clear. If you recognize a battle between firms and short sellers, short the stock and wait a few months. Unfortunately, the author explains that this is often not possible or costly because of the actions taken by the firms. This is sad because we cannot capitalize on such profit opportunities directly. However, the evidence clearly shows that it was historically a bad idea to bet against short sellers and buy shares of short-seller-fighting companies in the hope of a recovery. In my opinion, this is a very useful result as it shows that short sellers are not evil but just correct the problems that others are creating.
The results are robust after controlling for the major factors
To provide further evidence that the underperformance of short-seller-fighting firms is actually related to the firms themselves, the author next provides average alphas. For this purpose, he uses a four factor model consisting of the overall market (RMRF), Value (HML), Size (SMB), and Momentum (UMD). The following table summarizes the results.
Short-seller-fighting firms not only underperformed the market, they also generated negative monthly four-factor alpha of 2.4% over the year after their battle with short sellers. Interestingly, that is pretty much the same magnitude as for the previous results. Although negative exposures to Value and Momentum explain some of the underperformance, the negative four-factor-alphas therefore suggest that short-seller-fighting firms are indeed idiosyncratically flawed.
Conclusions and Further Ideas
The main takeaway of this paper is clearly the stylized battle between (flawed) firms and short sellers. I can also say this from my personal experience, it is always the same story. A company gets too expensive or involved in some type of problems, some short sellers disclose their positions or the media reports about it, and the company starts fighting. This week’s paper offers surprisingly clear advice for such situations: don’t buy the stock in hope of a recovery and if you hold it, get out as soon as possible.
While the sample of this paper is of course old and limited to the US, I believe there are two very plausible mechanisms driving the results. First, short selling is more difficult than long-only investing. To successfully implement (and survive) their strategy, short sellers really need conviction and they usually do deep research. Betting against them therefore doesn’t seem to be a good idea… Second, why should a company fight short sellers if it has nothing to hide? The usual argument against this is a story of greedy short sellers who spread misinformation to manipulate the stock price for their own benefit. That might be true in some cases and I don’t claim that all short sellers are good. However, I think it is hardly possible to manipulate prices over and over again in a functioning capital market and legal system.
Finally, the results speak for themselves. If short-seller-fighting firms don’t have problems, the returns after battles should be positive or at least close to zero. But at least in this sample, they are clearly not. From this perspective, we should therefore be thankful that informed short sellers exist. And for the management teams who hate them, the best way to keep short sellers away is to run a good and honest company…
- AgPa #72: Machine-Reading of Private Equity Prospectuses
- AgPa #71: Go Where the Earnings (per Share) Are
- AgPa #70: Equal vs. Market Cap Weights
- AgPa #69: Rebalancing Luck
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