When investors decide to bet on a company's share price falling (going 'short') on fundamental grounds rather than based on how its price chart looks they normally do so for one of two reasons.
Either they think the company is overvalued, given its business prospects. Or they think there is something potentially fraudulent about the business ranging from aggressive accounting to fabricated profits and assets.
Among investors as a whole, shorting stocks on the basis of valuation is likely to be more common than fraud-based shorts. That's because all of us regularly see stocks we believe are overvalued, whereas those that seem outright crooked come along less often. Yet many professional short sellers treat valuation shorts with caution.
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For a start, when a stock is overvalued, it frequently becomes even more overvalued before the bubble bursts. "After all, twice a silly price is not twice as silly; it's still just silly," as David Einhorn of Greenlight Capital put it last year.
Also, many short sellers are uncomfortable with the fact that they are shorting based only on the same public information that the rest of the market has. When shorting a fraud, they may feel more confident that they have uncovered facts that most investors have overlooked. Hence the professionals' advice "never short on valuation".
(Source: Alon Bochman/Activist Shorts)
The evidence
But do the facts back this up? There hasn't been much research in the area, but a recent article by Alon Bochman of investment firm Stepwise Capital provides an interesting insight.
Bochman looked at the outcome of 448 shorting campaigns between 2002 and 2014, using data from Activist Shorts (a research service that tracks public shorting campaigns by high-profile short sellers). He divided them into valuation shorts and fraud shorts based on the justification the short seller gave at the time, as recorded in the Activist Shorts database.
Bochman's results were striking. He found that the average return on all the shorted stocks for the duration of the short sellers' campaign was -14.2%.
That means that the short sellers were profitable on average, with around 65% of the short positions being successful (in the sense that the share price dropped). However, when the results were broken down by type of short, a very different picture emerged.
The average fraud short fell by a hefty -30%, while the average valuation short gained 3%. In other words, valuation shorts were net losers on average. This was helped by the fact that fraud shorts are more likely to include stocks that eventually drop to zero.
You can see this in the chart: the fraud shorts are heavily skewed towards large drops. Even in successful valuation shorts, the falls are likely to be more modest.
The lessons for investors
Bear in mind that this was an informal test of a small sample of shorts, rather than a detailed academic study. That said, it does seem to back the view that valuation shorting is a dangerous game, while the odds are a lot more favourable with fraud shorts.
The implications are obviously most useful to short sellers, a relatively small proportion of the investing population. (This reflects the risks and complexity of shorting, as explained below.) However, there could also be a lesson for other investors.
If you own a stock that professional investors describe as overvalued, you might not want to put much weight on their views. There's little evidence here that it's a useful warning sign of an impending drop, so you can afford to take the time to make up your own mind.
However, it may pay to listen to accusations of wrongdoing. That can be easier said than done: investors easily become attached to investments and resist criticism. But keeping an open mind to claims of fraud from credible short sellers could help you avoid significant losses.
Tread carefully shorting is a risky business
Short selling means selling a stock or other security that you don't currently own. If the stock subsequently falls in price, you can buy it back more cheaply and so profit from the difference. Of course, if it rises, you will have to buy it back at a higher price than you sold it for, and will make a loss.
Returns from shorting are the opposite of buying the security. If you buy a share, your maximum downside is 100% (where the share loses all its value), while your maximum gain is theoretically unlimited (it can keep going up and up). With a short, your maximum gain is 100% and your maximum loss is theoretically unlimited.
In practice, your broker will insist that you put up collateral ("margin") against the value of your short position and will close out losing positions if your margin falls below a minimum level (since they don't want to be on the hook if an investor runs up a huge loss and can't pay). This means that successful short sellers need to be good risk managers as much as insightful traders, to ensure that losses from trades can't get big enough to break them.
When you sell short, there is a buyer on the other end of the trade who will want take delivery of the stock. This means that you will need to borrow shares to deliver to them. You will have to pay a fee for this, which will depend on how difficult it is to borrow the stock. If borrow fees are high, then keeping the short going may quickly become unprofitable.
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