A while ago, I wrote a piece that I am extremely proud of called “Short Sellers are not the Bad Guys“. The note tries to take on the importance of short selling, especially in a marketplace where regulators absolutely cannot tackle every single problem and fraud that occurs. My key points were:
- Short sellers are an integral part of the markets.
- They raise questions about frauds, help the market recognize overvalued and risk-laden companies, and create sales for buyers.
- Additionally, they create cushions when stocks fall (by covering) and put ceilings on buyers panic situations
- The market is Darwinist; only the foolish will ignore the methods used to profit from when their due diligence tells them an equity or the macro markets will decline.
My points, in depth, were:
1. First, let’s look at it from a Darwinist market sentiment. The market is capable of going two ways, up and down. The numbers of the economy and of the individual companies drive which way the numbers are going to go. If they go up, a lot of people make money. But,if you recognize an economic slowdown or stunted growth in a company, should you not be allowed to find benefit in the research that drew you to those conclusions?
The market is very Darwinist – the smart and strong survive and can position themselves accordingly, the rest are carried off in whatever economic slowdown comes next, only to try and evolve and start over during the next upturn. Banks and big companies get a pass because of politics – if you’re not sharp enough to be able to position yourself accordingly during slowdowns, these companies are literally just taking the public’s money for themselves as the average retail investor gets fleeced.
In an economic crisis, the markets then simply become a vehicle for transferring your money to people that know how the “game is played”.
2. Secondly, let’s look at fraudulent companies.
Short sellers are like the spiders of your household. Sometimes, you let them go without killing them because you know they’re going to be killing other, smaller insects that don’t belong roaming around your house. Short sellers are like the constant dragnet being pulled over the market from an “on the ground” perspective – doing research the SEC doesn’t have the time or the funding to do, and raising issues to regulators that they may not have noticed themselves.
Short sellers are absolutely instrumental in pointing out fraudulent companies and they keep institutions and public corporations healthily aware of the scrutiny they are under when they choose to become a public entity. It’s fun being public – insiders usually make a massive sum of money and sometimes the shareholders can take a ride with them. The cost of being public is being subjected to the ongoing scrutiny of your required public disclosures.
A good CEO, playing by the rules, supports short sellers because he/she knows they’re valuable. Sometimes they even offer valuable insight to companies that they can use – very similar to activist shareholders. Companies that know they’re acting in a questionable manner often get combative and ad hominem with short sellers, leading the American public to believe that the corporations are the “good” party and that the short sellers are the “evil, Un-American” party. The funny thing is that usually when a company goes ad hominem, it’s just the opposite.
3. Lest we forget companies that are simply overvalued – short sellers do a great job pointing out stocks where the market has become too speculative and has put too big of a multiple on stocks that are risk laden.
Even if you don’t invest short, short sellers could be crucial in pointing out reasons to keep you out of long investments.
The issue is that when you’re long a company, in the general consensus, you’re innocent until your case is proven guilty. If you’re short, you’re automatically guilty until you can prove your innocence through the stock moving the way you want. Even then, people will reject your short thesis, just because it’s a short thesis.
Without being able to sell short, we’re essentially dealing with an even more “rigged” market than our market already is, as a product of the Federal Reserve. I believe regulators generally try to do the right thing and act as quickly as possible – but they are burden by time constraints, budgetary constraints, and limited resources.
In the recent case of short sellers uncovering questionable levels of formaldehyde in Lumber Liquidators’ laminated wood products, think about how many men, women and children would be breathing this in without knowing about it – but for the work put in by short sellers, who tipped off the media. Now, think about where this case is heading – the public has been made aware and the company is likely going to have to take responsive measures.
Think about the affect on families from this story breaking. Does it matter to you that the person who discovered this negligence had a pecuniary interest? Did it matter to anyone that Harry Markopolos was a competitor of Bernie Madoff’s when he blew the whistle and stood to gain from Madoff’s loss? It’s just simple: sometimes, when people are motivated by competition or monetary remuneration, they’re the only ones that will put the work in necessary to cut through the bullshit. And, like with any job, the quality and honesty of your work will determine your payout.
The next time that you read about the “evil and manipulative” shorts, or read some bullshit calling shorts liars and crooks, just remember: most of us are simply skeptics by nature, most of us think being a public company is a privilege, and most of us simply seek the truth.
Read more on the Lumber Liquidators toxic formaldehyde tests here.