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Short circuit

In the aftermath of Carillion’s collapse and a ban on shorting the stock of German company Wirecard, should we worry about short selling, or embrace the practice as an important component of efficient markets and price discovery?
Short circuit

Short selling has a public relations problem. Periodically banned throughout history, it’s often wheeled out as a contributing factor when a company’s shares tank, with short sellers blamed for exacerbating declines in a stock’s price, or in some cases causing it.

Regulators in Germany used just such arguments on 18 February when they announced a ban on the short selling of Wirecard (Ger:WDI), one of the country’s leading financial services firms and a new and exciting member of the DAX. With Deutsche Bank (Ger:DBK) and Commerzbank (Ger:CBK) looking like two drunks in a bar, Wirecard is seen as something of a saviour for Germany’s embattled financial services industry (and we feared the City would lose out to Frankfurt...).

But should all those hedge funds and short-term traders really get blamed when a company’s stock gets trashed? Does the action of borrowing stock to sell, in the hope of being able to buy it back later at a much cheaper price, really lead to shares falling in value, or, in the worst cases, companies failing?

Firstly, of course, short selling affects a stock’s price by affecting the supply of the stock in the open market, as well as its perception among other investors by way of price discovery. What we need to know is whether this matters (it does), but more importantly whether it matters for good or bad reasons.

The 10 most shorted stocks 
Share% shortFunds shorting
Arrow Global12.00%9
Ultra Electronics11.10%9
Metro Bank10.70%8
Debenhams10.40%3
Marks & Spencer 9.30%7
Pearson 9.30%10
AA 9.10%6
Anglo American9.10%7
Jupiter Fund Mgmt8.00%10
IQE7.60%5
Source: ShortTracker, as at 11 March 2019

Wirecard

As ever when it comes to short selling, it seems that regulators are trying to cure the symptom and not the disease. Bafin, the German equivalent of the Financial Conduct Authority (FCA), is the latest to fall into this trap, announcing last month a ban on investors taking out net short positions on Wirecard. The company’s stock had been tanking for several weeks following a series of investigative reports in our sister publication, the Financial Times. It was decided by the regulators overseeing Germany’s financial system that these share price falls were not simply a function of the market responding to negative news, but that they were a direct result of short sellers targeting the stock.

“There is a risk that an impact exerted on the share price of Wirecard AG as a result of net short positions being entered into or existing net short positions being increased will cause excessive price movements in the share price of Wirecard AG, given this company’s importance for the economy,” Bafin said.

The regulator added that Wirecard had suffered a series of “short attacks” from 2008 through 2016 that were followed and facilitated by negative reporting in the media, adding that “short-sellers profited from entering into certain positions, resulting in corresponding decreases in the share price of Wirecard AG”.

The fact that short sellers have been on the prowl for so long because of dubious accounting and rapid expansion is forgotten by the regulator. If short sellers are bullies, Wirecard needs to stand up to them by presenting investors with the facts, not crawl to the headmaster to exclude them for a few weeks.

We’ve been here before…

Banning short selling is nothing new, although in the case of Wirecard it is unusual for the regulator to deliver protection to a single company. More recently, during the great financial crisis of 2008-09, US regulators banned short selling of bank stocks, while similar measures were taken during the height of the 2010-11 European sovereign debt crisis.

The Security Exchange Commission, the US body overseeing markets, announcing the short sales ban on US financial stocks in 2008, summed up how regulators view the practice: “Unbridled short selling is contributing to the recent sudden price declines in the securities of financial institutions unrelated to true price valuation.”

“Unrelated to true price valuation” – those words are important and problematic. Firstly, what is ‘true valuation’? You can work out expected free cash, enterprise value – Ebitda (earnings before interest, tax, depreciation and amortisation) – and price/earnings (PE) ratios until you are bored senseless, but the basic tenet of any market is that the value is only ever what the market is prepared to offer. If markets are selling down stocks aggressively it’s reflective of a deep concern about a company, a sector, or even an entire economy – something shorts only serve to highlight.

Announcing temporary short-selling measures in relation to UK financial stocks in 2008, the old Financial Services Authority (FSA) said that “it was apparent that sharp share price declines in individual banks were likely to lead to pressure on their funding and thus create a self-fulfilling loop”.

But this just isn’t so. Research carried out on these bans following the crisis showed they in fact tended to reduce market liquidity and slow down price discovery, while failing to prevent declines based on economic fundamentals.

And while there may be validity to an emergency ban on short selling for a sector in crisis – such as banks in 2008-09 – the rationale behind preventing the practice for individual stocks in normal market conditions is suspect, if not just plain wrong.

Theories aplenty

What happens when you put 10 economists in a room? You’ll get 11 opinions. The old joke pokes fun at the profession, but it’s not far from the truth.

The interesting thing about short selling is that – unsurprisingly – the academic research is similarly split. A model laid down by economist Edward Miller in 1977 argues that a ban on short selling leads to higher prices. This is because the ban means stock prices only reflect the valuations of bulls and bears who actually own the stock – those who are bearish but do not own the stock are excluded and therefore have no effect on the price. Subsequent studies have shown that risk-neutral investors will adjust their valuations to reflect a ban on short sales. Risk-averse investors may even be affected by a shorting ban to the extent that they perceive – because of the ban – even greater risk and therefore require higher returns, ie lower prices for the stock. In other words, there is plenty to suggest short selling has an impact on price discovery; we just cannot agree on what that impact is. Behavioural economics comes into play here – investors are not always rational.

So this handles price discovery – to an extent – but what of actual fundamentals? Does short selling affect the fundamental valuation of a stock? Research in 2013 argues that a kind of temporary negative feedback loop can occur, especially in financial stocks, as these are subject to leverage constraints. If they are close to breaching these, the short-term pressure exerted by targeted short selling can force them to liquidate assets, affecting funding costs. Similarly, it may be that the shorting helps increase volatility in the share price, leading to uncertainty about true fundamentals, which ultimately leaves creditors declining to roll over short-term funding.

A 2014 Cass Business School study paper looking at examples from 2008-09 and 2010-11 suggests the reverse – that a ban leads to more volatility, greater declines in stock prices and higher likelihood of default. That’s because a ban suggests weakness to investors, and they become more risk-averse towards a stock as a result. The point is that banning short selling does not stop a company getting wiped out – it may delay it for a while, but it could just as easily speed up the process.

Shorts help price discovery. As ‘activist shorts’, they shine a torchlight on management and accounts that the usually positive sell-side brokers fail to do. If long-term investors are bailing, banning short selling is not going to help.

Carillion: a case study in failure

The collapse of Carillion is probably one of the most famous cases of shorts getting it right. Following its failed merger with Balfour Beatty (BBY), numerous hedge funds trawled the company accounts and figured something wasn’t right. About a fifth of the stock was out on loan – ie sold short – for two-and-a-half years before it went belly up.

Now the failures and mismanagement of Carillion are well documented and exhaustively written about. The question is: did the heavy shorting of the stock make it harder for Carillion to survive?

When hedge funds make tens of millions from the failure of a large listed company that employs thousands of workers up and down the country, it’s easy to see why shorting gets such a bad reputation. How can these elite hedgies sleep at night knowing they profited from other people’s misery? Well, aside no doubt from the decent claret it buys, the answer is simple – they may have profited from the misfortune of others, but they did not contribute to that bad luck. If anything, they were the ones most loudly and discernibly warning that things were wrong.

Clearly the hedge funds that shorted the stock read the company accounts better than some of the sell-side analysts did. They understood the business was creaking long before we heard about any profit warnings. This is itself an important part of price discovery. The shorts were sounding alarm bells on behalf of other investors who – it turns out – should have heeded the warning. In this case, the shorts performed a valuable service for investors; it was not their fault that others did not listen.

But did the act of selling company stock short in itself contribute to the failings of the company? Of course it did not; short selling is merely the symptom of the illness, rather than its cause. It happens because smart investors spot, for instance, that there is something wrong with the accounting, or the balance sheet, or structural shifts in a sector that others are slower to spy.

Indeed, research conducted on the Turkish stock market suggests that short sellers are essential to price discovery and the efficiency of markets. This study, published in the Journal of Financial Stability, demonstrates that increased short-selling activity is associated with higher liquidity and decreased volatility. The authors even suggest that any ban on short sales “may be detrimental for financial stability and market quality”.

And it must be remembered that shorts are taking a risk like any other investor, without the same risk/reward ratio. Theoretically, a stock can rise forever, meaning for a traditional long investor the potential upside is limitless, while the downside is always limited to the current price of the stock. For short sellers the reverse is true – the downside is limitless while the upside is always capped at the valuation of the stock. The most a short seller can hope is that the company goes bust and the stock goes to zero.

They get it wrong, too. Another stock that was up there at the same time as Carillion at the top of the short interest table was Wm Morrison (MRW) which was targeted for a variety of reasons as it was seen as the weakest of the big four supermarkets. Only it turned out to be a false alarm. Under the excellent stewardship of chief executive Dave Potts, the supermarket group has turned things around. Shorts were on the wrong side of that one – they contributed as much to the success of Morrison’s as they did to the failure of Carillion; that is, very little indeed except to cast a glaring spotlight on the management and finances of the companies.

Another was Ocado (OCDO) – among the most heavily shorted stocks of 2016, hedge funds got it badly wrong. In several well-publicised deals, chief executive Tim Steiner managed to deliver on the promise that buy-and-hold investors had counted on. The stock has risen fourfold in value since then.

I would argue that this is the biggest defence of short selling. If they really contributed to stock declines, Ocado would have had a harder time than it has. It took a while for Mr Steiner to convince us, but he got there – the shorts had zero influence.

 

In the firing line

The question for investors is who’s in the short-selling firing line now? Construction group Kier (KIE), all too similar to Carillion in many ways, was one of the most shorted stocks up until recently, but the collapse in the share price – accurately predicted by the shorts – has meant the amount of short interest has declined sharply. The clever hedge funds made their money and got out, although around 2-3 per cent of shares are still out on loan to short sellers.

Marks and Spencer (MKS) is still among the most shorted stocks at present (see table, page 25), with around 10 per cent of shares out on loan. Headlines in 2018 talked about hedge funds taking out an £800m bet against the retailer. The company’s share price has declined around 50 per cent in four years. A recent turnaround has seen the stock recover, but a £600m rights issue and 40 per cent cut to the dividend as part of a strategic tie-up with Ocado has cast doubt on this, with the shares slumping more than 12 per cent in a single day in February. Shorts could not have guessed that a major strategic tie-up would be so costly, but their central thesis – that M&S shares are overvalued – is still being proved right. I don’t particularly see how the short sellers contributed to the stock’s malaise; rather it’s the stuffy clothing and lack of online presence that is the trouble.

Other heavily shorted stocks include Debenhams (DEB) and Ultra Electronics (ULE). Debenhams has had well-documented problems with falling high-street sales, rising rents and spiralling debt. It has eschewed help from Mike Ashley’s Sports Direct (SPD), but it could yet go the way of House of Fraser. Indeed, what is interesting about Debenhams is that while the stock has collapsed by around 90 per cent since 2015 to almost nothing, the shorts still sniff opportunity. Unlike Kier, short interest remains high as sellers target a complete collapse.

Ultra Electronics has talked up a better game of late, but a new chief executive in place could reset expectations (see box on p26). This may well prove the moment the shorts come good. Investors should pay attention here to the way the short interest has risen steadily over time and is now at its highest ever.

Another of the most shorted stocks is Metro Bank (MTRO) – its fall from grace has been rather spectacular: accounting errors, FCA investigations and emergency rights issues sinking the stock to all-time lows. No one who watched the short interest on Metro shares rise from a meagre 1.5 per cent at the start of 2018 to around 7 per cent by January 2019 could not say they weren’t warned. In fact, the shares started to tumble just as the short sellers really took hold from around March last year. You could argue that the shorts had an impact – and you may be right – but only in as much as they warned investors about what was to come.