Shares in the online video marketing firm Blinkx crashed last Thursday.
On the day, the stock lost 32% and almost a quarter of the company’s shares changed hands. You might assume the company had issued a massive profit warning, but you’d be wrong. What happened was a bear raid.
It turned out that the panic was down to a blog written by Harvard academic Benjamin Edelman. He published a report highlighting concerns about two businesses that Blinkx acquired a few years ago.
According to Edelman, they use questionable tactics to direct internet traffic to Blinkx in order to earn advertising revenue. And in his view, these disreputable online tactics aren’t sustainable; so investors should question Blinkx’s strong reported revenue growth.
He also pointed out that Blinkx has a higher revenue per employee ratio than its peers, implying it either has a better, more efficient business model, or it is padding its revenue line.
That set off a royal panic. Blinkx strongly refuted the assertions, but to no avail. Many investors ended up selling off their shares at a fraction of their value.
Owners of Blinkx shares won’t agree with me, but today, I want to explain why I think short sellers are a good thing for investors.
Short sellers crash stocks
Let me start by explaining exactly what ‘short selling‘ is.
If we believe a share is overvalued and will fall, we can express our view by short selling. For example, a pension fund might lend us 100 Blinkx shares in return for a small fee (we don’t own these shares, we’ve borrowed them).
We sell them in the market at 200p and receive the £200 proceeds. A negative research report is then published which causes a sharp fall in the share price to 110p. We buy the 100 shares back from the market at 110p and return them to the bank. This costs us £110 so we’ve made a £90 profit on the deal.
But why is an academic such as Edelman writing about Blinkx anyway? Well, Mr Edelman disclosed that his research was commissioned by two unnamed investment firms, neither of whom has changed their position in Blinkx as a result. He also says that he was not asked by them to publicise his findings.
It could be that these anonymous investors are already short of Blinkx stock, and this research provided more support for their stance. We do know that one short seller which has gone public – a company called Muddy Waters Research – has claimed it has already benefited from the share price collapse.
Why I’m in favour of short selling
Now, a lot of people don’t like short sellers. And it’s easy to see why. Benefiting from bad news feels slightly immoral, or at least in bad taste. After all, lots of investors will have lost money.
During the financial crisis, many countries, including the UK and US, acted to ban short selling of financial shares, because at the time, it seemed possible for short sellers to drive banks into insolvency by relentlessly selling borrowed shares.
But I believe shorting is generally a good thing. Why? Because it can lead to more accurate share prices. The market exists to allocate capital efficiently, but in order for the system to work, it has to have accurate information.
It’s a common tactic for a hedge fund to short a company’s stock and then publicise the decision. If their arguments are weak, it won’t have an impact on the shares. However, if the stock market is too optimistic about a company, it’s in everyone’s interests to have that error corrected.
Don’t make the same mistake
Regardless, there is a big message for investors here. Blinkx has a complex business model, which made it especially vulnerable to a bear raid. I suspect many shareholders who panicked didn’t really understand how Blinkx makes money. They probably lacked conviction and it didn’t take much to push them overboard even after the stock had fallen a lot.
And this is the key point. If you hold a share with these characteristics, you need to do your homework and be confident in the story. Otherwise, leave it alone.
I think it’s also important for companies to explain themselves clearly. It can be all too easy for management to fall into technical jargon and to dress things up so they sound clever. When you hear this kind of guff from management, then the alarm bells should be ringing.
The best investment stories are the simple ones. And if you business is complicated, then you have to communicate your message in the most simple terms.