The author's intention is to provide transparency into the short-selling process and into participants' motivations. In the process, I will chalk out specific situations where securities have become overpriced either due to unsubstantiable expectations or temporary non-fundamental reasons.
Investors have access to a fair amount of advice on how to select stocks to purchase. Hopefully these anecdotes will provide a few checkpoints to aid in identifying situations where the market price of a security significantly exceeds its fair value - i.e. holders should either sell into an irrational bid, or should be cognizant that the market mark might not hold in the future. Otherwise, this blog will serve as a reminder of hubris when the author's favorite short position leads to the end of his career.
What is short selling?
To "sell short" is to borrow a security from a holder and sell it to a current bidder. The borrower is obliged to provide the owner with any cash flows associated with the security (dividends or interest coupons). Aside from special arrangements, the original holder has the ability to call back the stock at any point in time - i.e. demand that the borrower return the stock.
The cash generated from the transaction is generally left with the broker as collateral against the stock loan. If the price of the security (and therefore the loan) increases against this cash balance, the borrower may have to post additional collateral, depending on the margin requirements of the broker. If margin is allowed, the borrower generally pays a higher interest rate on the amount by which the loan price exceeds the cash balance.
In practice, the short sell transaction is generally closed out at the borrower's discretion, when the short-seller repurchases the security and delivers it to the lender.
Stock-loan departments at brokerages are the primary facilitators of this trade, and large passives (mutual funds, index funds) are the main source of stock to be lent out. The intermediaries benefit from a cut of the stock-loan interest as well as from incremental fees on margin accounts; stock-loan departments are also marketed as a service to attract prime brokerage clients. The stock lenders benefit from generating incremental returns on paper they do not intend to dispose of anytime soon.
Why would someone sell short?
Let's take a step back and examine the mechanics of the secondary market.
Prices are determined by traders whose estimates of the value of a long-term business seem to change at microsecond intervals. As such, each trade represents the buyer's belief that the security is underpriced, and the seller's estimate that there's no long-term benefit to declining the bid. In a perfectly rational secondary market, there would be no trades except by those necessitated by current needs for cash, and those would occur within a range of fair values. In practice, security prices fluctuate for a variety of reasons, several of which are uncorrelated to the value of the paper. It is important to remember that the price of a security in the secondary market does not affect the underlying business (unless they're relying on cheap equity financing to maintain a flawed business plan).
Irrationally high prices relative to fair value usually exist in situations where bidders do not have appropriate information, and where several participants (brokers, management, bankers, and fund managers) have incentives to maintain an information imbalance. This is generally the area where short-sellers participate, and attempt to discourage further destruction of capital by releasing facts that help clarify the situation for potential investors. On occasion, overpriced scenarios arise when there is non-fundamental demand for a security (e.g. ETF inclusion), and holders are unaware of the transcience of the source of demand.
The value-oriented short seller looks at securities as representing ownership of cash flows from the underlying assets. As such, they would sell short when they believe the current purchasers have a significantly incorrect estimate of the value of those assets, or if the latter is paying a premium for reasons unrelated to value. In doing so, the short seller is engaging in time & liquidity arbitrage, and expects a future scenario where holders will be willing to sell around a fair value, and current bidders will not be market participants.
There are three possible outcomes to this trade:
- The short-seller is wrong in their analysis, and the company generates cash at rates in excess of this estimate; eventually the short-seller must repurchase the stock at a fair value in excess of their estimate.
- Bidders at inflated price levels have enough capital to purchase most of the outstanding stock of the company, staving the realization of capital destruction till a later date.
- Bidders at inflated prices run out of cash; new bidders fail to emerge; stock holders are willing to sell the stock near fair value, the short-seller purchases the stock and delivers to the lender.
1 & 3 are generally facilitated by any flow of information which helps participants correct their estimate of fair value. 2 is a function of irrational allocators' ability to raise capital.
Of note, the only true "losers" in third scenario are the bidders who overpaid initially. However, as the some of the holders had assumed this price was reflective of fair value, they tend to feel depressed when market prices return to rational levels.
Of another ilk
The author's focus is on directional stock-specific short-selling. Other short-sellers include brokers, high-frequency traders & price theorists, macro funds, and convertible arbitrage funds. Brokers use their balance sheet to facilitate trades and hope that their transaction fees cover changes in prices; HFT, relative value trade on the notion than security prices across time and across securities with similar characteristics offer insight into future security pricing; macro funds trade on the idea that aggregate prices reflect aggregate fundamentals; true convertible arbitrage funds short stock against the implied equity value of their convertible bond holdings. The actions of the latter two groups have provided interesting opportunities in the past.
Admittedly, there are unscrupulous short-sellers out there who attempt to drive down prices by shorting in volume. However - as with momentum traders on the other end of the spectrum - these actions create large discrepancies of price to fundamental value - i.e. buying opportunities. Occasionally, holders might sell at levels below fair-value, taking in price action as an indicator of value. Such investors should not be entrusted with your capital in the first place, as they are incapable of independent diligence. It is important to remember that, as secondary market participants, short-sellers cannot affect the fundamental value of the business.
* The astute reader will surmise that the downside extends to public vilification and potentially career-destroying scrutiny. The upside is limited to the author's sense of gratification in facilitating information flow. Also, there's the outside chance that short-selling opportunities will dry up, if more holders decide to sell into irrational bids. Previous efforts by more notable writers indicate that rationality is not quite osmotic.
