10

Q1

ARE YOU SHORT?

THE CASE FOR SHORT SELLING
Abstract
So long as capitalist nations possess stock markets, investment banking firms, and short selling restrictions,
profitable short selling opportunities will always exist. Overly bullish market cycles, overvalued stocks, hot
investment themes, slick marketing by issuers and underwriters, faulty business plans, poor management and
outright fraud all conspire to create attractive short selling opportunities for the astute (or cynical) investor. Yet,
short selling is dominated by hedge funds and proprietary trading desks. Outside of buying inverse exchange
traded funds, few individual investors actually short individual securities or allocate a portion of their portfolio
to short selling strategies. This brief makes the case in support of individual investors pursuing short selling
opportunities.

http://theshortsell.blogspot.com
Introduction

So long as capitalist nations possess stock markets, investment banking firms, and
short selling restrictions, profitable short selling opportunities will always exist.
Overly bullish market cycles, overvalued stocks, hot investment themes, slick
marketing by issuers and underwriters, faulty business plans, poor management
and outright fraud all conspire to create attractive short selling opportunities for the
astute (or cynical) investor. Yet, short selling is dominated by hedge funds and
proprietary trading desks. Outside of buying inverse exchange traded funds, few
individual investors actually short individual securities or allocate a portion of their
portfolio to short selling strategies. This brief makes the case in support of
individual investors pursuing short selling opportunities.

Part one of this paper will review a sample of academic studies to help illustrate
three major points: (1) that short selling leads to abnormal returns, (2) that there is
theoretical justification for short selling, and (3) that successful short selling is
based not on the possession of inside information but on effective processing of
publicly available information.

Part two of this paper will draw upon the authors ten years of investment banking
experience to provide anecdotal evidence to further bolster the case for short
selling.

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PART I

Does Short Selling Lead to Abnormal Returns?

There has been a large body of academic research dedicated to studying the
relationship between high short interest and returns. In order to keep this paper
brief, the author has decided to highlight a few classic studies along with more
recent ones to help illustrate the potential for profits under a short selling strategy.

Many academic studies have concluded that selling short provides abnormal
returns. Asquith and Meulbroek (An Empirical Investigation of Short Interest
(1995)) detected a strong negative correlation between short interest and
subsequent returns, both during the time the stocks were heavily shorted and over
the following two years. In addition, the abnormal returns were more negative for
firms that were heavily shorted for more than one month. The authors concluded
that short interest does indeed convey negative information.

Asquith, Pathak and Ritter (Short Interest, Institutional Ownership and Stock
Returns (2005)) provide consistent evidence that high short interest is followed by
lower stock returns.

In more recent research, Boehmer, Jones and Zhang (Which Shorts Are Informed?
(2008)) found that short sellers were extremely well informed and that a value
weighted portfolio of heavily shorted stocks underperformed lightly shorted stocks
by 15.6% on an annualized basis. In addition, Engelberg, Reed and Ringgenberg
(Buy on the Rumour, [Short] Sell on the News (2009)) also confirmed that abnormal
short selling does in fact lead to lower future returns.


Is There a Theoretical Justification For Short Selling?

Why can short selling provide abnormal returns? Studies have found that stock
prices contain an upward bias, which results in overvalued securities.

Asquith and Meulbroek (An Empirical Investigation of Short Interest (1995)) stated
that their study provides a foundation for the view that stock prices reflect positive
information more efficiently than negative information.

Edward Miller (Bounded Efficient Markets: A New Wrinkle to the EMH (1987))
suggested that stock prices are bounded by limits set by the buying and short selling
of informed investors. The upper limits of stock prices that are set by short sellers
will stop the increase in the stock price if the potential return of short selling the
security is greater than the costs of executing the short sale transaction. Due to the
restrictions placed on short selling (institutional prohibitions, transaction costs,

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borrowable shares) investors are well advised to look for mispriced stocks to sell
because more overvalued than undervalued stocks can be identified.

Similarly, Miller (Risk, Uncertainty and Divergence of Opinion (1977)) found that in
a market with short selling restrictions (ex. institutional prohibitions, borrowing
ability, costs) the demand for a particular security comes from a minority who hold
the most optimistic expectations about it. The presence of a substantial number of
well-informed investors will prevent the existence of significantly undervalued
securities. However, there may be securities with prices that may have been bid up
to excessive levels by an overly optimistic (badly informed) minority.

Figlewski (The Informational Effects of Restrictions of Short Sales: Some Empirical
Evidence (1981)) stated that if short selling is restrictive, investors buy a security in
which they have a favourable opinion but take no position in which they have an
unfavourable opinion, thus creating an upward bias.


How Do Short Sellers Realize Abnormal Profits?

Short sellers are often portrayed in a negative manner by corporate issuers and
other investors. Often times they are accused of being market manipulators by
spreading false rumors. Although there have been cases where short sellers have
attempted to drive down the price of a stock illegally, a recent study by Engelberg,
Reed and Ringgenberg (Buy on the Rumor, [Sell] on the News (2009)) concludes
otherwise.

Accordingly, in the aforementioned study, the authors conclude that the projected
outcome of short sellers trades is twice as likely to be profitable in the wake of a
news release concerning the corporate issuers

Furthermore, short sellers on average trade on publicly available information as
opposed to uncovering information before it becomes public. In fact, Engelberg, et
al. demonstrates that short sellers generally trade at the same times as everyone
else. In the few instances in which short sellers show different timing, they tend to
trade after other traders.

So what makes a successful short seller? It appears that successful short sellers are
simply good information processors. One of Engelberg, et al.s main conclusions is
that the main source of short sellers advantage is in their ability to process publicly
available information. The authors note that abnormal short selling unconditionally
predicts lower future returns, and that this effect is largely concentrated around
news events. In other words, a short sellers most informative trades are in response
to newly released public news, which is consistent with the interpretation that short
sellers are good information processors.

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One could conclude that short sellers read and trade on more than just the headline
of a companys news release. In fact, successful short sellers base their contrary
opinions on being fully informed on companies and their industries. Being informed
includes digesting all of the publicly available information that a company releases,
including information-rich sources like prospectuses and notes to the financial
statements. Reading and analyzing companies newly released information takes
time in some cases, and it is little wonder that in certain instances some short sellers
trade later than other investors.


Why Are You Not Short?

Few individual traders actually sell stocks short. In fact, individual traders account
for only 1% - 2% of overall shorting volume (Boehmer, Jones and Zhang (2008)).
The majority of shorting is from institutions and stock exchange members trading as
principals.

Even though it has been found that short selling can yield profitable results, why do
individuals not short sell more? A number of reasons could explain this lack of
activity:

1) As noted above, effective short selling entails a high degree of information
processing. Processing information requires time and resources and often
the individual investor does not possess these in abundance.

2) Short selling has a number of different costs associated with it, including:
- Regular trading costs
- Stock borrowing costs
- Opportunity costs (i.e. a broker may not pay interest to individuals
on their short sale proceeds), and
- Collateral requirements

3) Short selling also has a number of specific risks, including:
- Recall risk (i.e. the stock lender can terminate the loan at any time
and if the individual can not find a replacement lender he may be
forced to close out the short position at a loss), and
- Collateral call risk (i.e. if the price of a shorted stock increases, the
short seller must put up additional collateral)


Part I Summary

Due to the variety of costs and risks associated with implementing short sale
transactions, individual investors represent a very small percentage of total short
sale volume. Yet, based on a number of academic studies, investors should allocate a

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percentage of their portfolios to short selling opportunities as short selling has been
demonstrated to yield abnormal returns.

Studies have found that stock prices contain an upward bias, thus creating an
opportunity for the astute short seller. Due to the restrictions placed on short
selling, most investors will buy a stock if they hold a favourable view but will do
nothing if they hold an unfavourable view. This dynamic creates an upward bias in
stock prices resulting in the existence of more overvalued stocks than undervalued
ones.

Given that there are more overvalued stocks than undervalued stocks and that short
selling can yield abnormal profits, how do short sellers actually realize this market
opportunity? Quite simply, successful short sellers are effective processors of
publicly available information. Short sellers can effectively analyze a companys
financial information and know how to recognize overvalued stocks.


PART II

Observations From an Investment Banker

Based on the authors 10 years of investment banking and capital markets
experience, he is able to draw upon a number of observations that bolsters the case
for short selling that will ultimately help him to identify short selling opportunities.
Although the author is not attempting to predict the direction of stock markets, he
will attempt to identify short selling opportunities given his background and
experience.

Observation Number 1: Dont Believe The Hype

Public Enemys Chuck D. may not have been thinking about overhyped stock market
investment themes when he uttered the lyrics Dont Believe The Hype, but short
sellers are very aware of this investment trend. In his time the author has been
witness to a number of hot investment themes, only to see most of them fizzle out
while leaving shareholders holding investments that are worth a fraction of what
they were at the peak of the hype. From technology companies and donut stores to
publicly listed private equity funds and hedge fund companies, all promised
abnormal positive returns and many investors followed. The results, however, have
been mostly disappointing for those with long positions.

Observation Number 2: Reading is Good For You

Investment bankers and their advisors spend inordinate amounts of time on
preparing an offering prospectus, especially one for an initial public offering. All
facets of the companys operations need to be disclosed and if an investor takes the

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time to read through major sections of it, one can be quite enlightened about a
particular company or industry. However, investment bankers also spend
inordinate amounts of time on marketing information that essentially captures an
offerings selling points in a concise and slick manner. Attention spans are short so
many investors rely on the greensheet or road show presentation to glean an
investments merits and to make subsequent decisions. A careful read of a
companys prospectus can yield a number of potential problems in a companys
business strategy.

Similarly, notes to the financial statements, although cumbersome to read, often
contain a treasure trove of valuable information. Notes to the financial statements
are often overlooked by many stock market participants, resulting in potential short
selling profits for those that do spend time sifting through this information.

Observation Number 3: The This Time is Different Fallacy

From when the author first began buying stocks in the mid-nineties, throughout his
MBA years and continuing on through his years in the capital markets, he learned
that there are certain industries that have historically been unable to generate
positive cash flows or earnings over the long-term. These industries are
characterized by having poor pricing power, high fixed costs, and overcapacity.
However, when optimism among equity investors runs high they flock to these
industries thinking that this time is going to be different. In the long run it rarely is.

Observation Number 4: Acute Memory Loss

As investors are learning painfully again, bubbles are part of the market cycle yet
most portfolios are caught off-guard when these bubbles eventually burst. From the
South Sea and Mississippi bubbles of many years ago to more recent bubbles like
housing, these wild swings in valuations will always occur so long as the free
markets exist. Some bubbles, like the leveraged buyout boom in the 1980s and then
again in the mid-2000s, actually occurred during a relatively close timeline.

Observation Number 5: The Hunter Eventually Is Put Against the Wall

Many companies have relied on acquisitions as their primary growth strategy. So
long as the debt and equity markets remain open to these types of companies, they
can carry-on with this strategy. As the number of acquisitions increase, so do the
size of the acquisitions as the company needs to meet its aggressive growth targets.
In many cases, the proposed synergies of these acquisitions fail to materialize,
operating performance suffers and the once favourable financing environment
disappears. At this point the acquiring company is unable to access growth financing
or is subject to a higher cost of capital. From pallet manufacturers to funeral home
operators, examples of failed acquisition strategies are plentiful.

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Works Consulted

Asquith, P. and L. Meulbroek, 1995, An Empirical Investigation of Short Interest,
Unpublished Working Paper, M.I.T.

Asquith, P., P. Pathak, and J. Ritter, 2005, Short Interest, Institutional Ownership,
and Stock Returns, Journal of Financial Economics 78, 243-276.

Boehmer, E., C. Jones, and X. Zhang, 2008, Which Shorts Are Informed? Journal of
Finance 63, 491-527.

Engelberg, J., A. Reed, and M. Ringgenberg, 2009, Buy on the Rumour, [Short] Sell
on the News: Short Sellers, News, and Information Processing, First Draft,
University of North Carolina.

Miller, E., 1987, Bounded Efficient Markets: A New Wrinkle to the EMH, Journal of
Portfolio Management 13.

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