Reasons to short a stock fall broadly into two “buckets”: fraud and valuation. Fraud shorts are stocks where the (short) investor believes the company is misleading the public about its business. This can range from mild and small-scale, such as aggressive but GAAP-defensible accounting, all the way up to massive and brazen fraud, such as fictitious revenue and profits. Let’s Gowex is a recent and spectacular example of the latter. Valuation shorts, on the other hand, are stocks that the investor thinks are simply too expensive based on the underlying value of the business. For example, I read a pitch about a year and a half ago that pointed out that Tesla (TSLA) was trading at over four times what Geely (a Chinese automaker) paid to acquire Volvo, and there was no way Tesla could be worth four Volvos . . . I remember thinking the pitch sounded interesting. It was certainly well-researched. I’m still not sure Tesla’s current market cap is justified (apparently, neither is the CEO, Elon Musk), but I’m so glad I passed on this short 18 months ago: TSLA is up more than 500% since the pitch.
Valuation shorts have a bad reputation on Wall Street. You may be right in the long run, but you may not be able to hold the position long enough to get there. As David Einhorn puts it, “We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.”
Valuation shorts are a dicey proposition on intellectual grounds, too. John Hempton, who is the chief investment officer at Bronte Capital and publishes one of my favorite investment blogs, puts it this way: “In a valuation short we are working on the same information as everyone else has. This makes me uncomfortable. There is an arrogance in suggesting we can analyze the information better than anyone else. We find it harder to answer the question of what we see when others don’t and hence harder to justify the position at all.”
I was curious whether valuation shorts work as a whole, and have recently had occasion to test this question using a new research service called Activist Shorts Research. They have compiled data on more than 400 campaigns by noted short-sellers from 2002 to the present. The returns look like this:
The mean price change (not including dividends), indicated by the blue line, was −14.2% over an entire “campaign,” which can be arbitrarily long. Additionally, 65% of campaigns were “successful” in the sense that the price of the target stock dropped since the campaign was announced. In 4% of campaigns, the price dropped 99% or more. These figures sound quite good, but it is important to note the sample is biased because the service does not cover all short-sellers, only the “best” and “most public” ones. These two groups likely overlap but not completely.
Despite the biases of the overall sample, the question I was most interested in was whether valuation shorts work better than fraud shorts. For each campaign in the dataset, we have a “Primary Allegation” which is the reason the short-seller used to publicly justify the short call. The reasons provided are many and varied, but I have grouped them into the two buckets we are interested in. The results are stark:
Short campaigns that allege a stock is overvalued are wrong as a group: the target stock rises 3% over the life of the campaign, on average. Shorts that allege fraud are much more effective: the target stock drops 30% on average. We can see this result in some more detail by comparing return distributions:
Fraud short campaigns are much more likely to identify stocks whose prices ultimately drop to zero. This skews the entire return distribution to the left, as compared with that of valuation shorts.
In conclusion, it seems the poor reputation valuation shorts have is at least partially deserved. Even when we look at some of the best-known and most-memorable short campaigns of the past decade, valuation shorts significantly under-perform fraud shorts.
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