The Bright Side of Short Sellers
I once wrote a defense of Bill Ackman‘s short selling of Herbalife. I argued that for all short sellers get criticized they may in fact be performing a service.
I believe I now have a less ambiguous case to support this thesis.
Whitney Tilson is a hedge fund manager who took a significant short position against the company Lumber Liquidators (LL). He went public and excoriated the company and its management to anyone who would listen. The most alarming of his claims was that Lumber Liquidators was selling laminate flooring that exceeded California’s air quality standards for formaldehyde.
After Tilson made the allegations (backed by testing he had performed), the company doubled down on its product and in fact lowered prices to sell more. (They are “liquidators” after all.)
Eventually, Tilson was able to direct the attention of 60 Minutes to the company. 60 Minutes produced a report that couldn’t have been better suited to Tilson’s purposes. The company responded by offering free indoor air quality tests, which may be of questionable value, to customers. Primary on the page including the offer is this:
Recently some questions have been raised about our laminate products. Let me make one thing very clear – our laminate products, all of our products, are 100% safe.
These attacks are driven by a small group of short-selling investors who are working together for the sole purpose of making money by lowering our stock price. They are using any means to try and scare our customers with inaccurate allegations. Their motives and methods are wrong and we will fight these false attacks on all fronts.
You might recognize this narrative of evil, short-selling hedge fund managers making false claims about a great main-street American business reselling Chinese laminate flooring.
The narrative holds that short-sellers will deceive since they have a financial incentive to see the company do poorly. And the narrative requires you to stop thinking right at that point.
If you continue thinking and recognize that the company defending itself from accusations has an even bigger incentive to see itself do well. If Tilson is proven wrong, he has a lot of other positions. Most of the management of Lumber Liquidators, in contrast, rely on the company for their day jobs. If Tilson has a conflict of interest, the conflict is only that much greater for the management of Lumber Liquidators. If the worst happens, those people will be barely employable.
It’s easy to sit back and get mad that Tilson has gotten rich off the miseries of a company that was doing just fine before he focused his attention on it. But is it actually preferable that a company continue to sell a product that violates indoor air quality standards indefinitely simply because we find aggressive, public short selling by already-rich people distasteful?
I think it’s worth comparing Tilson and 60 Minutes. Tilson is a hedge fund manager shorting stocks and destroying a business to make a profit. 60 Minutes is a journalistic organization destroying a business and inviting people to watch them do it. They profit from doing so by selling advertising to show to those watching the spectacle.
Painting by Gustave Caillebotte
Why is journalism considered the Fourth Estate while shorting is considered evil? Short-sellers at least accrue the most benefits to themselves when their accusations reveal genuine wrongdoing. Journalists instead accrue the most benefits to themselves when their accusations are salacious. Why is investigative journalism then considered so much more noble than investigative short selling?
I wasn’t aware short-selling was evil. Was there a memo I missed?
I’m not kidding. I’ve heard people complain about LOTS of things, but never short selling. The closest I’ve personally heard (and happily participated in myself) is certain forms of vulture capitalism — borrowing money to buy out companies and sell them for scrap, basically killing off fully viable companies because you’re so leveraged that killing it quickly for a small profit makes you a TON more than making more by running it over the long term. (Plus, generally you owe money back, so you can’t hold…)Report
What people like Tilson and Ackman do spreads the risk of failure not just to the company itself, but also to banks and other third parties. And by “betting on failure” and doing what they can to drive the stock price down, they are destroying capital, destroying jobs, destroying production, and producing nothing of value to the system at all.
Or so the theory goes.
Whether the theory is right or not may well be irrelevant. There have been attempts by governments to regulate short selling, often to regulate it out of existence, since at least the time when Amsterdam was the financial capital of the world and the exchange of stocks grew more sophisticated than cash-on-the-spot-for-equity. For as long as there have been and for as long in the future as there are futures, calls, credit, and options, there have been and will be short sales in one form or another. So better to make room for them in the system and at least steer the practice towards helping the public realize something of benefit.Report
Yep, short selling is supposedly evil.
Short selling was also outlawed for certain companies in the aftermath of the housing collapse because of reasons falling in line with the logic outlined by Burt. IME, most of the animosity directed at short sellers is very much blaming the messenger. People seem to think the bad thing is people saying bad things about bad things rather than the companies who originally created the bad thing in the first place.Report
I don’t think this is quite right, @vikram-bath
Short sellers aren’t just the messenger; they’re also the people who profit from other people’s losses.Report
At great risk to their own capital positionReport
I can short the dollar by putting money in silver.
That’s not shortselling, because it’s far less dangerous!!Report
Also depends on if they are right, and did the research & work to prove they are right, that the target firm is bad or harmful. In that case, they did the work regulators failed to do & they should get a profit.Report
I think it depends on whether the short-seller as valid evidence for their claims or not.
The claim in the lumbered liquidator case is easy to test and verify and is a bonafide violation of the law.
I can easily imagine situations where someone goes on a malicious gossip-spreading whisper campaign against a company that they decided to short.
As to why people think that News Journalists are more noble than hedge funders. Go back to all the psychological studies against price surging where people think there is something fundamentally unfair about raising prices on necessary items after some kind of natural disaster. I would suggest that one problem with economics, business, and those who adhere to those most above all is that they have a bit of an addiction to the counter-intuitive and what might be perceived as immoral by most people. People are complicated and innately use a whole range of thought patterns when examining the fairness of the situation or not. This includes not always being enthrall to the profit motive and believing that somethings or maybe many things are above the profit motive. People are people. I would suggest that economics and business might improve by understanding that there are other ways to look at situation besides economics and the profit motive and that’s okay. The general response from the market anarchists and purists is seemingly to jump up and down and say “You don’t understand economics!!!” This is why many on the left see the Market as being just as dogmatic to its adherents as Ultra-Orthodox Jews, Christian Fundamentalists, and Radical Islam are to their worldviews.
Another example, the plaintiff lawyers are also going against Lumber Liquidators.
http://www.krupnicklaw.com/lumber-liquidators-lawsuit.asp*
Who do you consider more noble? The Short Seller? The Plaintiff’s Lawyers? Both equally noble? What if the Lumber Liquidators people went on a rant against Trial Lawyers? Would you be on their side or the side of the trial lawyers and 60 minutes?
*Firm picked at random by Googling for Mass Tort and Lumber Liquidators.Report
The plaintiff lawyers got involved in the wake of the 60 Minutes investigation. In general, I’m not someone who blames people for trying to make money by exposing things that are true provided they are in fact true.Report
I don’t think you should dodge the question based on order. Plaintiffs’ attorneys may also blow the whistle on big things (and profit handsomely from doing so).Report
@vikram-bath @nevermoor
My question was more about testing perceptions and biases. I don’t suspect Vikram of this but I do suspect that that there are a lot of of people out there who would defend Short-Selling but have nothing but nasty things to say against plaintiff’s lawyers.
One thing that I think makes plaintiff’s law slightly different (and better) is that they have to find some with a plausible claim for damages and make a case based on law and facts in their complaint. They can be sanctioned and have their case dismissed and possibly be sued for failure to do so.Report
And don’t we sometimes think they’re heroes for doing it?Report
Sorry, the intention wasn’t to dodge. To be more explicit. I don’t have a problem with lawsuits being filed against companies or the people who file them or the people who represent the people who file them.Report
@saul-degraw
What is the difference in terminal values here? Short Selling is just the opposite of buying. You may be thinking that selling is the opposite of buying, but you can’t use normal selling to own less than 0. Regular selling is un-buying, while short selling is anti-buying.
Because buying and short selling are equal and opposite operations, the implications of them are identical. Just as short selling can be used for mischief, so can buying (it’s called Pump and Dump). Equally, both operations serve the same role in the market – to insert information into the market. Without short-selling pessimists have no way of entering their views into the market unless they already own some of the asset. This would make markets overly optimistic.
So why are people more suspicious of short selling than buying? Is it because people think optimism is better than accuracy? Imagine a fuel gauge that showed that you had more fuel than you actually do, or a weather forecast that told you it was going to be sunny, but it actually rains. Would people think that was better than a properly-pessimistic forecast?
I believe the real reason people find short-selling more sinister than buying is that people buy things all the time, but few people ever engage in short selling. And there is a known bug with the human brain that it more readily imputes sinister qualities to the unfamiliar than to the familiar.
That’s why I don’t take most people’s opinions on matters of economics very seriously. Most people don’t understand the underlying mechanisms well enough to have an opinion worth paying attention to.Report
Not exactly… for the companies where the feds banned short selling, most of their value is how much money they’re worth. Crush ’em enough, and they’re no longer big honking companies, but ittle bitty ones which are essentially WORTHLESS.
Short selling on Normal Companies is completely and utterly harmless.
Short selling on financials, when it becomes a stampede, could have taken down more companies.Report
@james-k
Just as short selling can be used for mischief, so can buying (it’s called Pump and Dump).
While theoretically true, in reality, I think it’s a little more complicated, especially once we get out of the realm of the micro-cap stocks (where mischief is more likely to occur) and into the more expensive equities for well-capitalized companies.
Let’s look at 2008. You can’t pump and dump a company like Morgan Stanley, but when the markets were as volatile and investors were looking to capitalize on that volatility, had the temporary ban on short-selling not been put in place, it would have wreaked havoc on the markets and further exacerbated a crisis that already reached systemic levels.
By no means am I against short-selling nor am I against people risking capital in volatile markets and making very high returns doing so. However, I am under no impression that short selling and buying are equals if only because the former can cause all sorts of havoc in volatile markets that buying can’t do, especially when volatility starts to have systemic consequences.
Equally, both operations serve the same role in the market – to insert information into the market.
We agree.
Without short-selling pessimists have no way of entering their views into the market unless they already own some of the asset. This would make markets overly optimistic.
Technically, I don’t agree. I am going to assume that by “overly optimistic”, you are making an argument that absent short selling, market pessimism will not contribute in a way to appropriate reflect market pricing.
If that’s the case, I’m not sure if I agree with that. A respected Wall Street analyst that places a “Sell” recommendation on a stock on the basis that he/she believes its overpriced may have that information reflected in the market. Financial journalists, bloggers or just about anyone with the ability to publish an article and express its views about a company. Some companies will get more exposure than others but there’s plenty of pessimism in the financial press.
Also, investors need not short a stock to show its pessimism. They can just as easily buy put options, sell call options or buy credit default swaps as all three of them express pessimism to different degrees. As much as people criticized credit default swaps, premium prices proved to be an effective way of transmitting information to the market, far better than the ratings agencies.
I believe the real reason people find short-selling more sinister than buying is that people buy things all the time, but few people ever engage in short selling. And there is a known bug with the human brain that it more readily imputes sinister qualities to the unfamiliar than to the familiar.
I’ll go part of the way on this and give some credit to a lack of familiarity with what short selling entails, at least on the risk side (the same applies to private equity but that’s a different discussion). Short selling is far riskier than buying. At a $50 long position, the max loss is $50. At a $50 short position, the loss is limitless.
Some people see opportunism without seeing the risk, and there’s a negative connotation about what appears to be bringing down a company. However, someone like Bill Ackman isn’t going to risk $1 billion of money mostly not his own to short Herbalife if he and his team believed that the company was a not a viable company long-term.
It reminds me of some of the complaints about private equity. If companies are in a position where private equity capital is the only way they’re able to raise capital, I’d say there are issues.Report
Short-sellers who get in and get out at the right time can do well even if what they’re saying is complete BS. News organizations are risking their credibility, which is a real and potentially fragile asset.
Then here’s places like Drudge and Breitbart, where apparently credibility doesn’t matter. I don’t know what to do about that.Report
Yep. There have been cases of people using message boards to say good or bad things about penny stocks and then profiting from what happened. People have gone to jail for it. Most professional money managers would have a hard time with that kind of thing because (1) they are limited to investing in companies of a certain size, (2) as a result their comments can only have a limited effect on the stock price, and (3) they can only make money that way once before people stop reacting to what they say. Most short sellers actually already live in this third category. It’s a relative handful of investors whose word alone can significantly move a stock up or down.Report
@mike-schilling
Short-sellers who get in and get out at the right time can do well even if what they’re saying is complete BS. News organizations are risking their credibility, which is a real and potentially fragile asset.
It should be pointed out that the exact same harm can be done *without* short-selling.
If I spread false rumors about a company, I can either take a short position *before* doing that, and thus make a profit when the price goes below that, or I can just *buy* when it’s low and wait until the price corrects and sell, and make a profit from that.
Short selling just makes the fraud faster. But without it, the exact same fraud would happen.
Likewise, you can do the exact opposite two things with ‘anti-malicious rumors’. You can buy stock and then spread false good news about, and sell quickly (The pump and dump) or you could, in theory, be on the other side of someone else’s short. (Except this tends to happen on penny stocks that no one is shorting, so you can’t.)
If you are willing to lie about stocks and can do it in a manner that others will hear you, you can rip people off in the stock market. There’s no way to regulate that fact out of existence.
This fact, incidentally, is *actually* why people are dubious about behaviors like Ackerman. Not that he was selling short, but because he took a position in the market and then told people a lot of things that would result in his position being a good one. Those things were probably, in fact, *true*, but without knowing that, it looks identical to market manipulation.Report
Most of the management of
Lumber Liquidatorsevery existing business, in contrast, rely on the company for their day jobs. If Tilson has a conflict of interest, the conflict is only that much greater for the management ofLumber Liquidatorsevery existing business.And here I thought you were trying to defend capitalism. 🙂Report
Also this:
Why is journalism considered the Fourth Estate while shorting is considered evil?
Well, there’s shorting and then there’s shorting, no? One of the halmarks of contemporary capitalism is that actors within markets are supposed to be a) functionally anonymous and b) not have the power to unilaterally determine price (granted, the last one refers to market share, but the idea seems to apply just as well here). Whitney seems to violate both.Report
Is shorting evil the wat playing the Don’t Pass line is evil: they cheer when everyone cries and root for that outcome but are more or less powerless to create it?
If folks lie about companies to improve shorting, I’d think libel/slander or fraud laws should be sufficient, no?Report
If a company is driven out of business by false information, the liar is unlikely to have enough money to make the damage good. And even if he could, damages would be paid only to the owners of the company, not to the people who as a result lost their jobs.Report
So throw them in jail. It won’t bring back jobs but likely will impede the practice.Report
Publishing false information to manipulate the price of securities is a good way to end up in prison, though. It’s hard to catch anonymous spammers doing it, but big name short sellers making very public statements with their names on them are pretty easy to catch and convict.Report
@troublesome-frog @mike-schilling
Yea. I mean, the guy here didn’t say he was skeptical of their long-term business model in a changing world. He made a specific, provable claim. If it can’t be proved, he should be punished. If it can be, the company needs to account for it. Maybe not necessarily by going out of business (which does punish innocent parties). Then again, if LL didn’t cut corners, maybe they are less successful and fewer of the jobs exist in the first place.
Which brings up an interesting question: should we aim to protect jobs held by innocent parties but created through ill-gotten means?Report
There’s prison, yes. Also, contingency lawsuits, as Saul has mentioned in other contexts.
Additionally, I can’t help but point out that Mike’s point is orthogonal to the post’s. Just because it’s possible to do something badly doesn’t mean it must always be bad or that it should be illegal.Report
Agreed. I was responding to Kazzy’s point about there already being laws against doing this fradulently.Report
@mike-schilling
If a company is driven out of business by false information, the liar is unlikely to have enough money to make the damage good.
True, but with the more high profile short-sell scenarios, false information won’t have much of an impact, if only because I’d expect to see significant investors either come out publicly and dispute the claims or signal the market other ways, like increasing the investment.
I think that’s how Carl Icahn responded to Ackman’s Herbalife short.Report