How small investors are creating a world of pain for short sellers

Short-selling is the act of profiting from share prices going down. The short-seller borrows shares from someone who owns them (often an index fund), pays them a small fee for the rental, and sells them. They wait for the price to fall, buy the shares back for less than they sold for, return them to the owner, and pocket the profit.

But what happens if the price goes up? That’s what short-sellers of GameStop, a struggling US video-game retailer, just learned the hard way. Matthew Partridge goes into depth here, but put simply, lots of short-sellers have been betting against the stock because video games are increasingly sold online, even before you consider the impact of the pandemic on physical shops. Turnaround interest from activist investor Ryan Cohen had triggered a bit more optimism about the stock. But the big moves came when a gang of private investors clubbed together on social-media site Reddit to bet on the price rising. The scale of the bets drove the share price higher, forcing stretched short-sellers to cover their shorts by buying the stock, in turn sending it even higher. GameStop’s shares are now up around 300% since the start of the year. Short-sellers collectively lost about $6bn.

It’s not just GameStop

The story is a useful insight into how shorting can go wrong and why most private investors should avoid it. Profiting from shorting demands more time and attention than going long – you have to get your facts and timing right and if you don’t, the consequences can be severe. So while we do look at ideas for short trades in the magazine (again, see page 25), ensure you grasp the risks before you consider making such bets.

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More importantly for non-traders, this is yet another sign of extreme market excess. As John Authers says on Bloomberg, GameStop is just the most eye-catching example of shorts being “squeezed”. According to Andrew Lapthorne of Societe Generale, small firms in the US with the heaviest short interest have also made the sharpest share-price gains this year. This follows a woeful performance for shorting in 2020 – indeed, this week big short-seller Melvin Capital, headed by Gabe Plotkin, a manager with a strong record, raised $2.75bn from hedge fund tycoons Ken Griffin and Steve Cohen after taking heavy losses.

As Authers puts it, it’s not that the shorts have lost their touch, they just can’t fight the volume of money and exuberance in markets. “Fun and games like this are a symptom of too much liquidity leaving traders emboldened to take trades to excess.” Interest rates are likely to stay low. But fundamentals have a habit of reasserting themselves. And the more stretched markets get, the more likely a snapback becomes.

I wish I knew what discounted cash flow was, but I’m too embarrassed to ask

According to the concept of the “time value of money”, cash that you’re promised in the future is worth less than cash received today, because you can invest today’s money so that it grows tomorrow, or spend it on a larger quantity of goods than you could in the future (assuming that inflation and interest rates are positive, which is not always the case).

For example, if you have £1 and can invest it at an interest rate of 5%, then in a year you will have £1.05. This means the “future value” of £1 in one year is £1.05. Put it the other way around and the “present value” of £1 received in one year is £0.952. This is because £0.952 is the amount that would grow to £1, if invested at 5%.

This is the basis of “discounted cash flow”, or DCF analysis. If you plan to invest in an asset, then you need to have an idea of how much you should be happy to pay for it right now. How can you work that out? Well, when you invest your money in a company’s shares, or a bond, or any other income-producing asset, you are paying a lump sum today for the right to receive a sum or series of sums in the future.

DCF analysis is simply a way of working out what the present value of those expected future cash flows is. For example, one relatively straightforward option when valuing a share is to use the dividend discount model, where the real value of a share is considered to be the present value of the sum of all its future dividends.

This involves estimating future cash flows (easier said than done) and then applying a “discount rate”. The discount rate might be the prevailing interest rate (ie, the return you could get on cash), or more likely the rate you would expect to get on an investment that involves taking similar risks.

As should be clear, DCF analysis is hugely sensitive both to cash-flow estimates and the discount rate applied. The lower the discount rate, the higher the present value of future cash flows.