What short sellers do “should be illegal”, tweeted Tesla CEO Elon Musk earlier this month. He’s hardly the first person to lambast those who seek to profit from falling share prices. Shorting entails borrowing shares and selling them with a view to buying them back later at a lower price, before returning them to the owner. In the early 17th century regulators in Amsterdam banned them, holding them responsible for forcing down the share price of the Dutch East India company. Napoleon declared the practice treasonous. Shorts were also blamed for exacerbating the 1929 and 2008 market slumps.
Their bad reputation is unwarranted, however. By taking a sceptical view of indices or individual shares, they temper exuberance and stop market bubbles developing. “Much of the Wall Street [or City] infrastructure is built around promoting stocks – whether it be sell-side analysts who have little to gain from airing sceptical views or promotional management teams that grant themselves stock options and sell them at inflated prices,” says
Sahm Adrangi of Kerrisdale Capital Management. Shorts can help root out fraud and bolster overall liquidity by providing sellers to match buyers. What’s more, “as a group they are clever stock pickers”, as The Economist points out. Studies suggest that heavily shorted shares (those with a large percentage of the stock being shorted) tend to underperform their lightly shorted counterparts by up to 16% a year.
Seller beware
Nonetheless, it is an extremely risky undertaking. If you sell a stock short then the most you can make is the price at which you sell it – after the company falls to zero. But your losses are theoretically infinite since there is no upper limit on a share price. Given that equities have historically returned around 5% a year, after inflation is taken into account, it’s no surprise that most short-sellers struggle to make money from their short positions alone. Even legendary short-seller Jim Chanos has ended up losing money on his short positions over his career (his ‘long’ portfolio has offset this). Still, well chosen short positions can add value to your portfolio by hedging against market or industry downturns. Given the current state of the decade-long bull market, it could be worth considering. Even if you don’t intend to short shares, though, studying what short-sellers do can give you an idea of which type of shares you should ditch or avoid. Here are some key “red flags” that short-selling experts look for.