Friday, January 06, 2006

Short Sellers versus the Firm

In recent times, the relationship between short-sellers and the firm whose stock they are shorting has become acrimonious, if not caustic. Managements rant and rave at hedgies that have made a profession of selling short.

Shorts do provide a very useful service.

First of all, they do highlight accounting shenanigans and businesses that do not deserve to exist or draw capital. I can remember one company that sold a very high priced product which sold at about 7 or 8 times what a perfectly acceptable substitute product would sell for. The business had a negative gross margin and needless to say, had never made a profit. The ensuing short squeeze as a number of us discovered this "jewel" resulted in a move in the stock from its IPO of $10 to $18. Ultimately, under the weight of bad accounting, bad finance, and bad product, the business collapsed into oblivion.

Consequently, short sellers will provide liquidity to the marketplace...both as sellers when markets are eager to buy, but also as buyers, as markets get squeezed, and ultimately as they cover.

The attached link was brought to my attention by Value Investor Insight, one of the most useful resources I read. I have no financial interest in promoting their service; rather, I merely commend it as a useful and timely resource. Not only do they (Whitney Tilson et al) provide a regular monthly publication, but also intersperse the month with a bonus e-mail.

The article is written by a professor of finance at Yale, Owen Lamont, who has been a keen student of short-sellers. In this lengthy working paper, he examines the techniques that "angry" firms used to attack the short selling community, legal threats, attempts to impede stock lending practices etc. I have seen and experienced both, not only as a short-seller of stock but also as a corporate activist. Such activities by managements may provide near-term Pyrrhic victories, but in the end, tend to be pointless and ill-advised. As Lamont points out,companies taking ant-shorting actions have well-below normal returns in the subsequent year of -2% per month.

Go down fighting

The best way for a firm to act when it is under a short-sellers siege is to get them where it hurts. Provide honest accounting, decent finances, and a respectable return on capital. In short, run the business!


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