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Short selling is no easy way to make money

Short sellers are an ever-present and divisive part of the market. But the path activist investors have chosen to make money is riddled with complexities.

Jonathan ShapiroSenior reporter

Apr 8, 2024 – 5.00am

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In our coveted capital markets, no agents are more divisive than the plucky short sellers. While everyone is rooting for stocks – and their wealth – to rise, the shorts are on the other side of the trade, betting on falls and failures.

When they get things right, they’re hailed as vigilantes keeping the public markets honest. When they don’t, they’re branded reckless manipulators who prey on the panic they try to stoke.

Steve Carell as Mark Baum in The Big Short. In reality, short selling is unglamorous and extremely difficult. AP

Regardless of one’s view, they’ve stuck around, and it’s universally accepted that a market with a healthy level of short selling is more liquid and informed than one where such activity is restricted.

Over more than a decade of covering local and international markets, I’ve learnt a thing or two about this mysterious breed. If they had one piece of advice, it would be “don’t do it”.

There are easier ways to make money.

Short selling, which basically describes the process of borrowing shares, selling them and then buying them back at a hopefully lower price, is an extremely perilous activity. The main reason is that the risks are asymmetrically skewed against the shorter. If a stock halves, the short sellers make 50 per cent; if it doubles, they lose 100 per cent.

Short sellers also start from a handicapped position in that they must pay borrowing costs, and finance the dividend payments of any stocks they short.

Powerful forces

Also, there are so many forces working to push stock prices higher. For starters, stocks have tended to go up over time anyway.

In Australia, the forces are particularly powerful. Superannuation funds tend to put one-fifth of their assets into the Australian sharemarket. Although these institutional owners do tend to make their shares available to be shorted, they also provide a constant bid as inflows drive more buying.

Australia is also the land of positivity – if aggregate measures of analyst forecasts are any measure. Only about 5 per cent of the S&P/ASX 200 has an average sell rating. That brokers tend to favour buy recommendations shouldn’t surprise anyone. Their forecasts are a big driver of quantitative strategies, and cannot be ignored.

Hedge funds do lament that there is little policing of brokers writing positive research that might be flawed, but the consequences of critical research being incorrect are far more severe.

Thus, because a market seems programmed to go up, short sellers have to carefully pick their battles. Fund manager George Hadjia, who has worked with some experienced short sellers over the years, says the three main reasons to short stocks are all fraught with danger.

Often, the most bearish investors in a company aren’t the ones holding outright short positions.

Shorting stocks that might be fraudulent requires difficult and time-consuming work that, more often than not, does not align with the situation being exposed. Even the best fraud hunters have lost money or made very little even if they had been instrumental in exposing bad actors.

Shorting a company’s shares because they are expensive is also not a reliable strategy. There is nothing to stop an expensive stock from getting dearer or reaching ludicrous heights.

Another strategy is to short companies with weak balance sheets that are carrying too much debt. The problem here is the stock price becomes highly sensitive to changes in interest rates – and becomes a volatile bond market short.

Also, when a company’s share price falls to a point where it implies imminent bankruptcy, the price becomes an options bet on survival. And options prices can swing spectacularly on incremental developments.

Some hedge funds have ventured out of the equity markets and into the debt market because the asymmetry works in their favour.

Bill Ackman, for instance, the founder and chief executive of Pershing Square Capital Management, turned to credit default swaps – corporate debt insurance contracts – in the weeks before March 2020 when the COVID-19 pandemic spread panic through global markets.

More recently, Bronte Capital has said it is shorting the corporate debt of vulnerable companies because a bond’s price is capped at its par value but could fall to zero if the business fails.

Shorting tends to be an exercise in risk management – it is about stock selection and successful short sellers have learnt how to stay in the game rather than use their investor capital to embark on moral crusades.

What about shorting in Australia? We know the controversial practice of activist shorting has all but gone away after the regulators issued guidance on the process and one activist was forced to back down after legal action.

Although the Australian Securities and Investments Commission says it does not have a problem with this activity, the perception is that activist shorts aren’t welcome.

Stressful and dangerous

We’ve seen only one short report lately and that involved Square, which has a primary listing in the United States.

Whether that’s positive or negative for our capital markets is an open debate, but regulators are taking comfort in the fact that these reports aren’t putting them on the back foot and pressuring them to look into the content of the reports or the conduct of the authors.

So, all in all, short selling has proved to be a tough way to make money. Those who do it say it’s stressful and dangerous to swim against the tide.

What does favour short sellers is that it’s never too late to get onto a trade. Other than securing the shares to short at a favourable price, there’s no major advantage to getting in early.

If a stock falls from $10 to $1, the short seller makes 90 per cent, but if a Johnny-come-lately shorts at $1 and the shares fall to 50¢, that’s a 50 per cent profit.

However, in the case of the early bird, the further dip from $1 to 50¢ adds only 5 per cent to the gains.

So, a short seller has to keep adding to the position to compound the returns but a long investor’s position in a winning trade grows and compounds without having to do anything.

Most short positions aren’t personal. They are often used to offset a long position or to bet based on a macro theme – such as the weakness in consumer spending or lithium. The corporate managers who do best are those who accept and face up to short sellers by explaining their concerns.

Mark Cuban, a well-known entrepreneur, has described short sellers as committed future buyers of his stock. Netflix’s Reed Hastings wrote an articulate letter about what his short-selling friends were missing. Elon Musk just trolled the shorts, the stock kept rising and they lost money and gave up. Now Tesla shares are falling, but most have given up on betting against him.

There are more forms of negativity than simply shorting. Often, the most bearish investors in a company aren’t the ones holding outright short positions. Rather they are running underweight positions relative to the market index in a traditional long-only portfolio. When that stock rises, the manager feels a pinch in the form of forgone performance, which can be just as costly as a short squeeze.

Thus, short sellers are here to stay, even if they’re being forced deeper into the shadows. The real scourge, though, is the market manipulators, and they tend to be on any side of the trade.

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Jonathan Shapiro writes about banking and finance, specialising in hedge funds, corporate debt, private equity and investment banking. He is based in Sydney. Connect with Jonathan on Twitter. Email Jonathan at jonathan.shapiro@copyright link

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