Take short sellers seriously

Short sellers get a bad press. But if they target a company you invest in, you need to take action quickly.

It's been a dramatic month for "attacks" by short sellers investors who profit when share prices fall, rather than rise (see below for how this works). Here in the UK, litigation financing company and Aim star stock Burford Capital saw its shares slide as well-known short-seller Muddy Waters published a long report criticising the company's accounting and corporate governance. Then US conglomerate GE came under attack from fraud investigator Harry Markopolos, in a 175-page report he wrote for an unnamed hedge fund. Both companies challenged the allegations, while Burford also made changes to its board, including replacing its chief financial officer.

Investors in both companies will be irritated, to say the least. Short sellers tend to get a bad press those who own shares in a target company are never going to welcome the attention of an investor who is betting against the share price. And the fact that some "shorts" can wreak havoc purely through reputation alone (as is the case with both Muddy Waters and Markopolos, who spotted Bernie Madoff's fraudulent activity well before his downfall), means there is the potential for conflicts of interest.

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Yet it would be a mistake to just shrug them off. "Activist" short sellers argue that they provide a service by bringing questionable or even fraudulent practices to the attention of the wider market. And their methods often work several studies have shown that shares with high levels of "short interest" tend to underperform their peers. A 2008 paper (Why do short interest levels predict stock returns?) by researchers Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, and Sorin Sorescu, argued that this is because short sellers are "highly informed traders" in other words, the added risks taken by short sellers (see below) incentivise them to do more work to understand a company fully.

The other point worth noting is that short sellers are often able to cast doubt on their targets because of complex accounting. Often this is down to the nature of the business involved. But it's a valuable reminder that, before you invest in an individual company, you need to examine its accounts thoroughly and have a clear understanding of what they are actually saying.

None of this is to say that the attacks on either Burford Capital or GE are justified short sellers are by no means infallible. However, if you are an investor in one of these companies or another that is targeted by shorts (or you are thinking of investing in one), then you have some homework to do. You must engage with the arguments being made by the short seller and satisfy yourself that they are wrong. And if you can't do that, then the only logical option is to sell.

I wish I knew what short selling was,but I'm too embarrassed to ask

When most investors put money in the stockmarket, they go "long" they buy shares in the hope that they will go up. Short selling is the opposite of this it's a method of profiting from a share price going down. Here's how it works. A short seller borrows the shares from someone who already owns them (usually a fund manager), and sells them in the open market. Then, if and when the price falls, the short seller buys the shares back at the lower price, returns them to the lender, and pockets the profit.

So, for example, say you want to sell shares in Acme Widgets short. You borrow 10,000 shares from your local index fund provider in return for a small fee, and sell them at £1 a share. So you now have £10,000 (less your borrowing cost), but you owe the index fund 10,000 Acme shares. Thankfully, Acme issues a profit warning later that month, and the share price falls to 80p per share as a result. You buy 10,000 shares back for £8,000. You return the shares, and enjoy a £2,000 profit.That's the mechanics.

So why would you do it? Professional short sellers try to hunt down companies with weak or even fraudulent business models, then bet against them. Shorts are often maligned, partly because company managements find them a convenient scapegoat, but short sellers in fact provide a valuable service sometimes helping to reveal the true state of an otherwise overhyped stock.

Shorting is also extremely risky and not something to be done lightly. If you buy a share, then the worst that can happen is that it goes to zero, and you lose 100% of your money. But with short selling your losses are technically unlimited, as there is no ceiling on how high a share price can rise. Also, in practice, spread betting is the only practical way for most retail investors to go short. This incurs the extra risk of being highly leveraged (in other words, you are betting with borrowed money), which magnifies any losses.