On December 19, 2012, a brash US hedge fund manager took the stage at a New York City investment conference and announced to the world he had shorted a nutritional supplement company called Herbalife. Over the course of a three-hour, 330-slide presentation, Bill Ackman laid out his argument for why Herbalife’s stock was going to fall to US$0.
Among those watching was Dan Loeb. Like Ackman, Loeb runs a prestigious hedge fund. Also like Ackman, Loeb is himself a billionaire. But when it came to Herbalife, Loeb’s opinion diverged from Ackman’s. After doing his own research, Loeb bought Herbalife’s stock — the exact opposite position to Ackman.
For many people, Loeb was on the side of good and Ackman the side of evil. Betting on a stock to collapse — potentially displacing employees, customers and shareholders in the process — seems unfair, possibly even immoral.
Securities regulators in many countries have long eyed short sellers with suspicion. Even in the United States, some regulators blamed short sellers for contributing to the 2008 financial crisis and banned short selling in about 1,000 financial stocks for months afterward.
That was a mistake: Later research by the US Federal Reserve found that the ban actually made the crisis worse. It exacerbated volatility, increased price declines and cost investors an additional US$500 million in trading costs. Ironically (or not, to readers familiar with short selling’s benefits), stock prices in the 1,000 stocks stabilized after the ban was removed.
Significant additional academic research confirmed the same idea: From a distance, short selling seems scary. But the data shows that it adds value. And no other economy stands to add more value by adopting a healthy, robust short-selling system than China’s.
China invites, short sellers decline
We say this, of course, because on March 2nd, the Shanghai-Hong Kong Stock Connect officially began to allow short selling. This isn’t, strictly speaking, China’s first foray into short seIling. It’s been possible to short Hong Kong shares since 1994, though the list of eligible securities has been limited and the reporting requirements imposed on investors rather onerous.
Likewise, mainland investors have been able to short A-shares since 2008. But these were minor excursions into short selling compared with the Stock Connect’s opening last month to short sellers around the world.
From afar, the motives of Chinese and Hong Kong regulators seem clear: Overall investor interest in the Stock Connect has been disappointing, so, like a restaurant adding a menu item to attract patrons, it added short selling to its roster.
But there is a problem: Investors aren’t shorting any shares. Literally none. As many readers know, the reason isn’t lack of demand. Nor is it that foreign investors have so much faith in the companies available to short that they refuse to wager on price declines.
As expected, shorting came with aggressive volume limitations — a limit of 1 percent of a stock’s daily trading volume, and 5 percent over 10 consecutive days — but with not a single share shorted, volume limitations clearly aren’t the only impediment.
Rather, the problem is a peculiar rule that requires shares shorted to be loaned to the short seller (who then immediately sells them, collects the cash, and hopes to buy back the stock at a lower price) by an “exchange participant”. This probably sounds reasonable to the layman, but the Stock Connect’s exchange participants are brokers, and the 11 brokers participating in this trial program must borrow shortable shares from the state-owned China Securities Finance Commission, and apparently they still don’t have available inventory to short.
So, whether by omission or commission, regulators have still effectively prohibited short selling.
Besides alleviating the image problems of the Stock Connect — which has thus far disappointed both long and short investors — regulators have compelling reasons to make creating a blossoming short-selling system a priority. As American investors, we’ve seen the evidence, read the studies, and lived through our own regulatory blunders around short-selling over the years. Were we invited to a policy meeting with regulators in charge of the Stock Connect, here’s the case we’d make.
In the American stock market, short sellers nearly always identify fraud far before stock exchanges or regulators see it, and they also expose poor and inefficient behaviors at legitimate companies. This healthy pressure and scrutiny often encourages companies to replace poorly performing managers or to divest parts of business that don’t fit well with a company’s strategy. Both of these functions — spotting fraud and pressuring inefficient behavior — add value to not only stock buyers, but also an economy writ large.
Some notable examples of problems found by short sellers — and not regulators — in the US markets include:
• Short-selling investment firm Muddy Waters exposed an entire slew of deceitful Chinese companies that listed their stocks in the US to raise money, but absconded with that money, defrauding investors. By finding and exposing the companies sooner, rather than later, Muddy Waters minimized the reputational damage to legitimate Chinese companies and sheltered investors from further losses. Nearly all financial frauds are discovered eventually, so the sooner this happens, the less damage occurs.
• Jim Chanos uncovered Enron, a large American energy company whose off-balance-sheet financing masked deteriorating economics, through in-depth study of the company’s financial statements. The company filed for bankruptcy and its two most recent CEOs were jailed for securities fraud and other charges.
• Zhou Xuhua, a 25-year-old former University of California Los Angeles finance Ph.D. student from China, tested wood flooring sold by Lumber Liquidators, an American company that had begun buying more flooring from a questionable Chinese supplier. He found excess formaldehyde, and wrote about it, prompting more famous short sellers to follow his advice, a national TV program investigation, and an inquiry from the US Congress into Lumber Liquidators.
Meanwhile, academic evidence that short selling has permanently impaired legitimate companies is virtually nonexistent.
A smoother ride
That’s not to say short sellers only serve to root out companies engaged in illegal behavior. They also serve as a check on normal market ebbs and flows, especially on the upside.
When stock prices are artificially low — as in the aftermath of the 2008 financial crisis — investors’ hunt for cheap stocks pulls prices back to appropriate levels. But when ebullient investors push the stocks of healthy, growing businesses to artificially high levels, investors’ only defense is to not buy the expensive stocks.
Short selling enables investors to manifest their view that any stock, including that of a healthy business, is too pricey. Doing so can help prevent the runaway markets that can lead to asset bubbles and painful crashes.
Short selling also has more plebeian uses, such as for hedging a portfolio against downside risk, or for creating strategies that deliver steady returns in any market conditions. For example, an investor may express her belief that a restaurant stock is best in the industry by investing, say, HK$1 million in that stock and short selling HK$200,000 in each of five competing restaurants. The investor here wants to bet exclusively on her ability to identify a winner, and wishes to remove overall industry price movement from her trade.
Strategies such as these are actually the far more common use of short selling. In fact, a study from Credit Suisse found that a scant 0.7 percent of hedge funds’ short sales were explicitly betting on a stock to decline. The vast majority were hedges or components of sophisticated strategies.
Because exchanges can track how much of each stock is sold short, short selling also provides market participants with additional information. To what extent the market, in aggregate, believes a stock will decline is valuable information to stock buyers.
Short selling also adds liquidity for buyers of stocks. Market makers who are allowed to sell short have a more powerful toolkit for maintaining a smooth, continuous market for their securities. The added liquidity reduces the bid-ask spread, which is another form of transaction cost.
All upside from here
American academics have actually studied short selling for years; long before the 2008 crisis. We’re not aware of a single study classifying short selling as a detriment.
The academic literature is strongly in favor of short selling, noting, among its benefits, the reduction of market bubbles, reduced co-movement of stocks (short selling makes stocks less correlated), lower likelihood of earnings manipulation, better price discovery, and greater market efficiency.
A 2006 study confirmed what the US Federal Reserve re-discovered after the US financial crisis: stocks with more restrictions on short selling experience greater volatility.
Company managers aren’t happy to see their stock shorted, but in the US, all major public companies have some level of their shares sold short at any time. It’s a fact of American markets. The best companies don’t worry about short sellers because they know the short sellers will be proven wrong eventually and no harm will be done in the meantime.
A 2004 study found that the companies that most aggressively fought short sellers, such as with lawsuits or accusations of market manipulation, had stock price declines of 42 percent, on average, in the following three years. Companies that fear short sellers often have dirty secrets.
Regulators often unwittingly target short selling when they really intend to target market manipulation. Ironically, short selling is one of the best ways to purge market manipulation.
A tremendous boost for China
Allowing international investors to short sell A-shares will add immense value to China. If it seems to cause any pain initially, it’s only pain that would have come out later — and in a much bigger way.
Trading “circuit breakers” and restrictions against “naked” shorting — whereby investors short shares that aren’t strictly matched to corresponding borrowed shares — are essential, as is keeping the identity of short sellers anonymous. Short selling should have no stigma.
Even today, nobody has yet been proven right or wrong on Herbalife. Some day, one side will, but it’s the conflict itself — and its expression in stock prices — that’s the real benefit to investors, economies, and societies.
Shorting provides a motivation for differing opinions to coexist — more motivation than the choice to simply buy or avoid buying a stock. Factories have quality control monitors and cities have policemen and detectives for the same reason: A motivation to find problems adds trust to a system and identifies problems before they become bigger.
The article first appeared in the May issue of Hong Kong Economic Journal Monthly
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