Why Should We Pay Attention to Short Sellers?

Generally short sellers are viewed as a force of evil, speculators, increasing the cost of government debt and endangering the confidence in listed financial institutions, hence causing systemic risk.

But Short Sellers Are Often Right!

Look for example at the developing story around Hewlett Packard (HP). Jim Chanos mentioned HP as a short candidate in June 2012. And now HP is in the midst of an accounting scandal. Who are the bad guys here? And how did he do it?

How did Chanos identify HP?

Chanos typically searches for problems instead of growth stories. He sees short candidates in roughly 4 areas of opportunity:

1. Debt-financed booms that go bust
2. Companies that are becoming technically obsolete, through creative destruction
3. Bad accounting: from earnings overstatement to outright fraud
4. Would be customer fads: extrapolation of one time success.

Chanos identified HP as a short candidate when they acquired Autonomy for a significant premium (see chart below). The acquisition and the price raised a red flag to Chanos. Chanos was short Autonomy at that time because of reason 3: bad accounting. We see now, for good reasons.

Source: Aswath Damodaran’s Blog: Musings on the Market

Autonomy was to Chanos another confirmation of HP’s dismal M&A track-record. Chanos, June 2012: “..Compaq impairment, EDS restructurings, Palm write-off, Autonomy revenue implosion…” 

“HP has been hiding the true costs of its R&D through acquisitions. Once the costs of these acquisitions are taken into account, revenues and cash flow at the company are “basically flat,” Chanos said.

To make things worse, Chanos also detected the computing market is in decline (E.g. Computers with hard drives vs. Tablets and Cloud Computing) and HP had no strategy to move to new profitable high-grounds. It was just waiting for accidents to happen.

So HP dealt with problem number 2 and acquired problem number 3 through Autonomy. Definitely a short candidate!

What if more investors had made this analysis? Should we listen more often to short sellers? What can we learn from short sellers like Jim Chanos? How do short sellers perform their analysis?

Article: How Jim Chanos Spotted the HP Scandal

First, Some History on Short Sellers

Short sellers are with us since financial markets exist. Jenny Anderson of the New York Times notes in 2008:

“…In the days when square-rigged galleons plied the spice route to the East, the Dutch outlawed a band of rebels that they feared might plunder their new-found riches.  The troublemakers were neither Barbary pirates nor Spanish spies—they were certain traders on the stock exchange in Amsterdam. Their offence: shorting the shares of the Dutch East India Company, purportedly the first company in the world to issue stock. 

Short sellers, who sell assets like stocks in the hope that the price will fall, have been reviled ever since. England banned them for much of the 18th and 19th centuries. Napoleon deemed them enemies of the state. And Germany’s last Kaiser enlisted them to attack American markets (or so some Americans feared)…”

Enemies of the State or an Accounting Police?

Contrary to the general public and policymakers view, the investment world respects short sellers and views them as the most fundamental analysts, the smarter, more independent thinkers outside the herd. James Montier, a famous investment strategist at GMO classifies short sellers as follows:

“…the short sellers I have met are among the most fundamental-oriented analysts I have come across. These guys, by and large, really take their analysis seriously (and so they should since their downside is effectively unlimited). So the continued backlash against short sellers as rumour mongers and conspirators simply leaves me shaking my head in bewilderment.

I can only assume that the people making these claims are either policy-makers pandering to shorted companies, or shorted companies themselves. Rather than being seen as some malignant force within the markets, in my experience short sellers are closer to accounting police – a job that the SEC at one time considered its remit…”

Ok, ok: from Napoleon’s enemies of the state to the accounting police, now some facts please!

Yes, Short Sellers Identify Overpriced Companies…

Owen Lamont (2012) recently updated his 2003 study. He studied battles between short sellers and firms from 1977 to 2002.

He finds the following: firms that started fighting short sellers show a monthly underperformance of 2% (!), for the 12 months after a firm started the battle.

Lamont finds a 1 year cumulative return of  – 24% and a 3 year cumulative return of – 42%. Pretty serious negative returns.

…and Short Sellers Detect Fraud, Insider Trading and Earnings Manipulation

And believe me it gets worse. The sample studied by Lamont showed that the majority of the firms undertaking actions against short sellers are subsequently revealed to be fraudulent.

Karpoff and Lou (2010) find short sellers anticipate revelations of misrepresentations of financial statements, which are material events (average 1 day share price declines of 18%!).

They also see the amount of short selling increases with the severity of the misrepresentation indicating short sellers sniff-out fraud, insider trading and earnings manipulation rather systematically.

Again some convincing evidence short sellers speed up the time-to-discovery and help deflate overpriced shared due to misstated earnings.

Does this sound familiar? At least in this case the company (HP) has picked another scapegoat for the fraud: Autonomy’s former management. The short seller (Chanos) escapes a court case, for now. The pattern however is clear: the financials were materially misstated and a short seller pointed it out and now management is playing the blame game.

So Who Are These People?

So shouldn’t we study more carefully what short sellers say, rather than disqualifying them as malignant? Shouldn’t we watch their presentations and think about what their analysis implies for our investments? If we want to listen tot them we at least have to know who they are!

Let’s look at what Jim Chanos had to say recently:

• See his presentation on Value Traps: this is where he identified HP as short candidate!
• Interview with Chanos in Graham & Doddsville 2012

We haven´t discussed him yet, but another famous short seller is David Einhorn. Yes, the short seller Dick Fuld (Lehman) wanted to crush. Luckily, gravity did its work and we can still enjoy Einhorn’s analyses:

• Recently Einhorn was at the Buttonwood conference and discussed the Fed. Europeans, think about what this says about Draghi, the ECB and the eurozone.
• For some background see this interview with Einhorn in Value Investor’s Insight

Other short sellers are Gerorge Soros, John Paulson, Steve Eisman, Michael Burry, Jamie Mai etc.

So How Do Short Sellers Analyze Companies?

Of course there is more on Chanos and Einhorn and other short sellers. However I’ll leave that for later posts or your own research. I think it’s time to take a class on what short sellers’ generally look for in company financials.

In this Guest Lecture, Katrhyn Staley, writer of The Art of Short Selling, explains how short sellers go to work. Pay attention and take notes.

As we’ve seen, it is a useful training for any investor.

Enjoy!

Reading list: