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Ideas Farm: If I were a crook...

A better plan for skulduggery than short selling.
Ideas Farm: If I were a crook...
  • Reasons not to be a short seller
  • Reasons retail investors should celebrate short sellers
  • Reasons the establishment should too
  • Loads of new idea generating data

One of the peculiar aspects of the recent Reddit ramps is that short sellers seem to have been cast as the enemy of retail investors. This is peculiar because usually those vilifying short sellers are establishment types (management, regulators, populist politicians, etc). Here we’re talking about an anti-establishment rabble that sees malfeasance in the activity of 'evil' shorts. 

This magazine lives to serve retail investors, so have we got it wrong by publicising London’s most shorted shares in our Ideas Farm data?

Just to be clear at the outset, I’m not suggesting that short selling is not used by stock manipulators. It often is.

But if I were a crook, shorting is something that I would be lukewarm about.

There are several things stacked against short-sellers that would put me off. Firstly, in general, the market tends to go up more than it goes down. While what is true of the market is not necessarily true of individual shares, it still suggests being short is not such a great place to be, especially when markets rise fast, as they have since March. 

A bigger consideration for short sellers is that their upside is limited but the downside is not; the opposite of long-only investors. When a short seller borrows a share to sell into the market, the best outcome is that the share will be valueless by the time the debt needs repaying. However, if the price goes up, there is no limit to how high it can go. That means huge losses can be incurred if a losing short position is not closed out quickly enough. 

And that leads us the final big negative. Short sellers have an inherently weak hand. If a share being shorted rises rapidly, to control risk short sellers are forced out of their trade because they have to buy shares to cover the ballooning liability (the increasingly expensive borrowed shares). 

This last factor is the nugget of genius in recent events in the shares of GameStop (US:GME) et al. There was a ridiculous level of short interest. This meant once prices started to go up in earnest, short sellers were forced to join in the buying frenzy. That added rocket fuel and created further pressure to close short positions. Ouch!

These off-putting characteristics of short selling means it often is an activity that attracts crusading obsessives (or the closest the investment world has to crusaders). That is why we think monitoring short interest is valuable to retail investors. Short interest is a red flag. It has served as a warning ahead of many of the highest profile stock disasters over the years: from Enron; to Carillion; to NMC; to Wirecard.

What’s more, despite the narrative we have seen shamelessly spun by some establishment types (eg, dodgy management teams and inept regulators), it is very hard for short selling to bring down a viable business. 

So, we continue to think that short sellers can provide a valuable service to retail investors by raising red flags. The establishment, in the form of auditors, regulators and non-executive directors, should pay attention, too. 

That said, like all Ideas Farm data, being aware of short interest should be part of a much broader research process. Short sellers are often wrong. Another case in point is this week’s significant reduction in short interest in some familiar names on our most-shorted list. These moves look like the result of short sellers limiting risk in reaction to last week's events rather than a reflection of a change in fundamental view.