Short sellers are the muggers of the financial industry.

 

This rant is inspired by a series of articles in the Toronto Globe & Mail examining “Stocks that are attracting lots of pessimism.”  Essentially they screened for the highest short interest ratios among Canadian and U.S. companies last week.  First of all, short sellers are neither optimistic or pessimistic.  They are the financial equivalent of muggers.  There’s a science to evil – a mugger will target reasonably well dressed people who have accidentally wandered into or near an alley, or perhaps along a street not well populated.  A really big dude might give you a hard time, so muggers avoid them.  The secret is examining all data that confirms vulnerability, and then attack.

It’s pretty much the same with short sellers.  Normally a company (or it’s stock) that seems vulnerable would simply be sold by investors.  What a short seller does is effectively sell more of the same stock, but he actually owns none of the stock at all (in any other situations, this would be immoral, unethical, and illegal) – but by putting more selling pressure on the stock (or bond or whatever security it is) he ‘creates’ an opportunity to buy it back lower down – which we call ‘covering.’  One Canadian company at the top of the ‘stocks that shine – among short sellers’ listed in the article is Stantec.  You can see the impact that a 61.7% short interest ratio (# of shares sold short divided by average daily volume) had on the stock price. 

When the most recent financial results were released the short sellers had to cover – by buying the shares in a frenzy in order to ‘deliver’ the stock that was sold short at a higher price.  This puts added upward pressure on the stock.  Volatility is not only caused, it is fanned.

From The Canadian Press, February 24, 2011 – 3:17 p.m. – “EDMONTON – Stantec Inc. (TSX:STN) reported net income of $25.1 million in the fourth quarter, up 9.6 per cent from a year earlier as the engineering and construction firm’s revenue grew to $310.9 million.”

A real investor in the company had to unfairly suffer (like being kicked by the mugger when you’re down) the exaggerated decline in the price simply so short sellers could create opportunities to rip him and the company off.  The investor is ripped off, because watching the stock get pummeled in daily trading likely caused some panic and many investors will have sold their stock in the company out of fear it would keep going down (adding more fuel for the short sellers again).  The investor was then deprived of the subsequent rise in the stock price he should have earned.  The company might have been keen to raise some needed capital, but the uncertainty caused by wild volatility in its stock price would make it difficult to determine a fair market price to issue stock at.  Everyone loses but the investment mugger.  The Washington Post was a U.S. stock that was at the top of the short sellers list of favourites.  It’s short interest ratio on the day this article appeared was 22.4%, which is very high in the U.S. market.  Notice the exact same ‘bastardized’ trading pattern.

Some will argue that this phenomenon (selling what your don’t own) helps make markets more efficient.  But that opinion is flawed – it assumes that the rationale for selling short is to deprive bad companies of money in public markets, and hence it is channeled into better companies.  Bullshit! Do only bad people get mugged?  Condoning this sort of abuse actually creates inefficiency.  These culprits have amassed huge dollars from innocent folks by dazzling them with fancy powerpoint presentations and dizzying promises of sky-high rates of return – and then they use these funds just to create and then exploit inefficiencies they cause under the guise of the loosely regulated misnomer “HEDGE” funds.  It’s appaling that they get away with it, but there are just too many service providers, lenders and trading platforms making money from it all to stop it.

So what?  Good question!  Since regulators won’t outlaw the practice – police tolerate muggers but at least it’s against the law – the best we can do is to occasionally ‘strike back’ whenever possible.  When I see these muggers stalking their prey, I will deliberately buy the stock that they’ve shorted and once in a blue moon I’ll get lucky and make money at their expense – while they are desperately out there trying to cover their short positions.  This is easier when you manage enough money to at least have marginal impact.  After all, the only reason they target a stock is because they have enough money to have an impact.  In order to short sell successfully, a number of ducks must line up:

– the float (all the stock out there trading) is not so large that even a big seller has no effect.

– average daily trading volume must be sufficient to be able to cover (buy back stock).

– there is negative press or rumours (often these are spread by the short sellers) that can be overblown in order to spook enough owners of the stock (retail investors are best) into selling (make a stampede) along with the shorts.

A funny story.  Remember the T. Eaton Co. Ltd.? (Eaton’s – a Canadian department store that was in business 130 years and went public briefly in 1998 only to declare bankrutsy in 1999; eventually bought by Sears).  Well, on a very boring day a long while ago I noticed the short sellers taking advantage of a thin (quiet summer day, no volumes) market  and deliberately putting pressure on the stock of this company.  I owned it, and for entertainment I decided to sell my stock aggressively alongside them (a double whammy on the downside for the stock price).  As it trended down, you could see they began to double down their bets, letting greed get the better of them and selling lots more stock they didn’t own.  My advantage?  I actually owned the stock I was selling.  When I’d had enough (lunch time), I began buying back the stock I’d sold higher up – so aggressively there was no room for them to get a fill (couldn’t cover their short positions).  I made a lot of money for clients that day, and the short sellers went home squealin’ like the pigs they were.  So in effect, I mugged the mugger.  Proud of myself?  Heck no.  In an orderly market, this whole scenario should not occur at at all.

My rant certainly won’t make short sellers go away, but with luck more informed investors will  know enough to check (there are services that reveal the short interest in publicly traded stocks) whether or not there’s actually something wrong with your investment, or whether it’s just that these nasty traders have decided to attack it.  There are options:

– Stay clear of the stocks they’re playing with – why provide the liquidity they crave?  Not fair to the companies behind the stocks unfortunately.

– Look for high short interest ratios – and a bit of analysis will tell you whether or not it’s worthing betting against the shorts.  We can try to make money when they desperately buy the stock back to cover.

– Be careful when you own those ‘darling’ stocks; with low or no short interest and almost everybody loves the stock and the company (media and investors), and all news is good news.  If there’s any chance at all that a rumour or a stumble in the company’s business should suddenly appear, then the devils will surely come.  Any selling pressure from a few disillusioned investors will be multiplied many-fold by these financial muggers.  I discuss how bad it can get when a darling stock loses its lustre in A Maverick Investor’s Guidebook.  It ain’t pretty.

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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One Response to Short sellers are the muggers of the financial industry.

  1. richard lote says:

    cheers Mal – hey your comments on short sellers is really myopic.
    short sellers are at time speculators just like long buyers; people with stock options can be short sellers, people with long positions are short sellers in different accounts and comparable industries like the rails, arbitragers are short sellers TSX vs NY etc. Brokerage companies have to have the stock in their portfolios and then have to lend them – why do mutual funds allow their stock to be loaned?
    Short sellers keep poor CEO’s honest or at least allow the shareholders to rally and try to can them; too bad that didn’t happen at Nortel which never had any good executives.

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