Short sellers carry a villain-like reputation in the investment industry. For example, occasionally a CEO will charge that inscrutable characters—who are shorting his stock—have spread false rumors, trying to send the stock’s price lower. Also, to some it seems “un-American” to profit on a business or asset that is losing value.
Short selling is the act of selling stock the investor doesn’t own. The investor borrows the shares from a brokerage firm, which is lending the shares from its own inventory or one of its customers. After a short sale, the investor will eventually “cover” his short position by buying back the stock. If his purchase price is lower than the original short-sale price, the investor earns a profit.
For the most part, the negative connotation toward short selling is misplaced. First, the majority of short selling in the stock market is due to investors who are trying to hedge against risk. Arbitrage strategies in which an investor may simultaneously buy the stock of a company being acquired and sell short the shares of the acquirer are regularly used to lock in profits and reduce risk.
Second, true professional short sellers are typically intelligent, above-board investors who often alert the markets and investors to overvalued securities and, in some cases, to fraud.
One of the best-known short sellers is Jim Chanos of Kynikos Associates (Kynikos is greek for cynic). Chanos is famous for spotting the fraud at Enron. While Wall Street was singing the praises of Enron’s new-era energy model, Chanos was digging into the financials and finding mysterious off-balance entities along with heavy insider stock selling. Chanos has said that the day Jeff Skilling resigned, he knew Enron was a fraud.
Selling stocks short is a difficult profession considering that, historically, the stock market advances in seven out of every 10 years. On the other hand, short selling can be hugely profitable. One massively profitable short sale that is still talked about today occurred when George Soros shorted the British pound in 1992 and made $1 billion. Soros had correctly predicted that the British government would not raise interest rates and, therefore, would have to devalue sterling in an event referred to as “Black Wednesday.”
Recently, a handful of investors found an arcane way to short the subprime mortgage market during the 2007-2009 credit crisis with derivatives called credit default swaps. These investors had discovered that many securitized bonds with investment-grade ratings of AAA to BBB were chock full of subprime mortgages underwritten as no-doc “liar loans,” two-year teaser rates, interest-only mortgages, and 125-percent loan-to-values. Their analysis told them that if home prices stopped going up, these mortgages would experience high defaults and the bonds would sink in price. As that scenario played out, this small group of investors made billions.
During 2008, Bear Stearns and Lehman Brothers both complained to the SEC that short sellers were partially responsible for the collapse in their stock prices. Chanos countered that Lehman had a $150 billion hole in its balance sheet, which can be explained only by executives who fraudulently overvalued their assets.
Professional short sellers who perform rigorous analysis can provide a useful check against over-optimistic assumptions. For the record, today Jim Chanos believes the Chinese property market is in a bubble.•
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.