If there’s one thing everybody on Wall Street agrees on it’s this: everyone wants to make money (and preferably, boatloads of it). But the hatred of short selling — and of the people doing it — is perhaps the second-most dearly held view.
[See: 9 Ways to Spot Value Trap Stocks.]
In the Street’s view, if you’re short selling stocks for a living, you’re virtually subhuman.
Even most self-directed individual investors hate short sellers.
But in fact the taboo practice of shorting a stock is a wonderful part of the U.S. securities market, and most investors owe a debt of gratitude to this oft-berated and widely misunderstood corner of the markets.
Here’s a quick look at short selling and five reasons you should be glad it’s a part of the stock market today.
What Is Short Selling?
Short sellers, or “shorts,” do the exact opposite of what “longs,” or buyers do. They bet on the price of a certain stock to fall. Specifically, they borrow shares from a real shareholder and then immediately sell those shares. If the stock falls, they can buy shares back at a lower price, return them, and keep the difference.
Instead of buy low, sell high, it’s sell high, then buy low.
Why Do People Hate It?
“Short-selling seems un-American to most people,” says Robert Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“Short sellers benefit when a company performs poorly, and rooting against a company’s success seems anathema to the American way,” Johnson says.
That’s one point of view. Another reason people might generally hate shorts is less about the American way and more about the primal part of the human brain.
In Vegas, craps is one of the most popular games for a reason: It’s very social, and everybody either makes or loses money together. Well, almost everybody.
When the shooter “craps out,” there’s a collective groan from the table as the croupiers rake bet after bet back into the house’s coffers. Most bettors are optimistic, wagering that the shooter won’t crap out on a given roll.
But not everyone.
The table often reserves its saltiest language for the contrarian betting on a flameout, whose only crime was making money while everyone else lost theirs.
5 Reasons to Love Short Selling
More independent, higher-quality, less conflicted research. “There’s a scarcity of analysts out there willing to say ‘strong sell,'” says Ben Axler of Spruce Point Capital Management, an investment firm focused on short-selling, value and special situation investing.
In fact, in 2017, only 6 percent of the 11,257 sell-side analyst ratings of Standard & Poor’s 500 stocks were “sell” recommendations, and there’s a reason for that: The analysts tend to work for banks with big investment banking divisions, which underwrite — or hope to underwrite — shares of the very stocks they rate.
Sell-side research is largely a quid pro quo game: You give our stock a good rating, and we’ll bring you our business from time to time. Investment banking business from a large publicly traded company can be very significant.
“It’s important for alternative research not being funded by the companies themselves to play a role in the market,” Axler says.
Shorts make markets more efficient. Imagine a market that banned all short selling.
There’d be no excess selling pressure on companies with out-of-control valuations, no incentive for shorts to provide exceptional investigative research informing the market more fully, no “short interest” figure to signal other investors of something fishy, fewer ways for funds, companies and individuals to hedge portfolio risks, and no profit incentive for anyone to uncover fraud.
Overall, you’d have a less-efficient, somewhat “dumber” market with a slight bullish bias, marginally more prone to bubbly activity.
That’s a lousy market, plain and simple.
Real social good can come of it. Some investors short stocks because they look overvalued, or to hedge their portfolio.
Others, like Carson Block and his firm Muddy Waters Research, engage in “activist” short selling — they look for companies engaged in illegal activity, fraudulent behavior, misleading accounting practices or other shenanigans. Then they short the stock, publish their research and trumpet their views.
Block argues activist shorts in particular can be a force for good, pointing to Lumber Liquidators (ticker: LL), a flooring company that “60 Minutes” profiled in 2015, finding it was selling Chinese-made laminate flooring with far more formaldehyde than legally allowed.
[See: 7 of the Best Stocks to Buy for 2018.]
Lawsuits and state and federal investigations followed, and the company stopped selling the potentially hazardous product.
“That was a real service that I think was done to society, not just the markets, by short sellers,” Block says. The “60 Minutes” profile followed intense scrutiny by short sellers alleging wrongdoing.
“It all started with some guys looking at LL’s margins saying, ‘Why are they so much better than their peers? There’s gotta be something fishy here.’ And it turns out there was,” Block says.
Disincentivizing bad behavior. Former Lumber Liquidators’ CEO Robert Lynch resigned after the revelations garnered intense scrutiny from the public and the government alike. LL stock plunged from about $120 a share in 2013 to under $15 a share 21 months later.
But Lumber Liquidators isn’t the only example of short sellers acting as canaries in the coal mine: Valeant Pharmaceuticals ( VRX), Enron, Allied Capital and Lehman Brothers are just a handful of public companies with illegal or unsustainable business practices that short sellers worked hard to expose.
The profit incentive inherent in short selling creates a new pocket of the market — a last resort beyond regulators — that serves to keep public companies honest, lest they be publicly hung out to dry.
Transparency. Shorts also enable more vigorous debates in the marketplace, leading to unprecedented transparency. Consider Herbalife ( HLF), the nutritional products company that two Wall Street titans, Bill Ackman and Carl Icahn, brought to the forefront in recent years. Ackman shorted it, while Icahn went long.
“This was a company that had controversial practices, and there was a lot of research disseminated on the short side and a lot of rebuttal from the company,” Block says.
“In many ways that was the marketplace of ideas and information — and the free markets — at their best,” Block says.
“And P.S., who won? Not the shorts. But the fact that all this transparency was brought to light was fantastic for investors,” Block says.
Reconsider the Bias Against Shorts
Our society has a profound distaste for bears, and short sellers in particular. And while there are shorts prone to hyperbole and borderline libel or defamation in a desperate attempt to make shares fall, those bad apples don’t represent the industry as a whole.
“Are there bad actors on the short side? Yeah, I’m sure,” Block says. “But usually these people don’t get much traction.”
“I think the market is efficient in the long-run,” Axler says. “If there’s a short seller putting out bad research, the market will quickly figure that out and ignore them.”
Also, the consequences for that behavior — lawsuits, fines, trading bans, jail — are extremely serious. Even operating in the gray can permanently ruin a firm’s brand.
Just as the behavior of religious extremists doesn’t make every follower of that faith a dangerous nutjob, short selling shouldn’t be characterized by its worst actors.
Aside from that, there’s a certain amount of hypocrisy at work when Wall Street rants against bears:
“Shorts talk their book on TV. They want to move the stock, that’s market manipulation!” Bulls do the same thing every day on almost any financial media network you can think of. Sometimes the company itself pumps the stock — it’s called a celebratory press release.
“Shorts take pleasure when stocks go down!” There’s nothing inherently wrong with this, and in fact, a market that does nothing but go up is a bubble destined to pop. Bulls have no problem bidding stocks exorbitantly higher, cherishing the short-seller’s pain all the while.
This hypocrisy runs deeper: The bullish bias is systemic. The New York Stock Exchange has a “circuit breaker” rule that halts trading for 15 minutes if stocks lose 7 percent in a day. Another halt happens at 13 percent, and if stocks lose 20 percent in a day — forget it! Everyone go home and give it a better try tomorrow.
There are no circuit breakers on the upside to prevent irrational exuberance.
Don’t Try This at Home
Short selling stocks is incredibly risky, since the upside is limited and the downside is potentially infinite — the exact opposite dynamic of buying and owning a stock. Individual investors should leave shorting to the pros.
Still, there are ways to bet against the market, or hedge your portfolio for a fall aside from shorting. Put options, covered calls, and many other options strategies can hedge your downside risk. And there are arguably too many inverse ETFs — some of theme leveraged — available to the common investor if they wish to make bearish short-term bets on the market’s direction.
Here too, it’s usually best not to. Talk to a financial professional if you’re interested in betting against the market in some way, shape or form.
Regardless, remember that short selling provides real benefits to the market, no matter how un-American or un-gentlemanly the optics feel to some observers.
Someone who makes money by shorting stock in a fraudulent company — or bringing that fraud to light — should not be confused by victims as the real villain.
The fraud, after all, existed independently of the short-seller. And the dice, not the other gambler, loses the craps player money.
[See: 8 Reasons to Avoid Short Selling Stocks.]
Fraud isn’t nearly as common as it was a century ago, but it’s still out there. It’s yet another reason investors should never invest more than they’re willing to lose, and always stay diversified.
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Short Selling: 5 Reasons to Love This Wall Street Taboo originally appeared on usnews.com
