Short sellers are often vilified in the investing world because they profit from a stock price decline. The fight between corporate insiders and short sellers is nothing new. Elon Musk's fight with Tesla short sellers captured the headlines for a long time. Bill Ackman's billion-dollar short bet against Herbalife is another iconic example of such a fight. In recent months, the trading frenzy at GameStop (GME) has again prompted a lot of discussions on the role of short sellers in the market. Despite the common narrative that short sellers are to blame for stock market manipulation and price decline, a healthy dose of short selling is vital for well-functioning capital markets.
An efficient capital market, where prices reflect accurate information about the company's fundamentals, allows CFOs to raise funds at an attractive price in the long run. Informationally efficient capital markets are also good at allocating capital to its best use: giving money to fundamentally strong firms while rationing it for the weak ones. Short sellers make an important contribution in making prices efficient, and therefore in the efficient allocation of capital across firms.
Since the short sellers profit from a price decline, they have strong incentives to discover bad news such as corporate wrongdoing, mismanagement, and accounting fraud. For informationally efficient capital markets, the discovery of bad news is as important as the arrival of good news. The CEOs and CFOs of a firm have all the incentives to release good news. It is the short sellers, and sometimes the regulators, who are in the business of discovering bad news and making markets more efficient in the process. Improved information efficiency that comes from the discovery of bad news helps good corporations separate themselves from bad ones. In the end, such a separation allows fundamentally strong firms to raise capital at an attractive rate.
Months before the collapse of Lehman Brothers, short seller David Einhorn made a famous speech describing some accounting discrepancies in Lehman’s 2008Q1 accounting statements. In September of the year, the truth came out, and Lehman's failure was for everyone to see. Early and accurate discovery of negative information can help investors, regulators, and CFOs alike. Academic research finds overwhelming evidence supporting the positive role short sellers play in improving market efficiency.
There are two other benefits of short selling that go beyond the discovery of bad news. Fearing these discoveries by short sellers, firms are likely to be more careful with their disclosures and corporate decisions in the first place. With their backs against the wall, corporate managers are likely to make better decisions when faced with heavy short-selling pressures. Such a disciplining effect improves the overall quality of corporate reporting, and it can also result in better performance in the long run. Tesla’s recent performance can be partly attributed to this disciplining effect of short sellers.
Second, short sellers play a vital role in keeping price bubbles under control. Stock investors can be broadly classified into two groups: optimists and pessimists. Optimists, who are bullish on the firm's prospects, can easily voice their opinion by buying more shares of the company, contributing to further price rise. Pessimists, on the other hand, can only voice their opinion by selling shares. In the absence of short selling, a pessimistic investor can only voice her opinion if she already has the stock in her portfolio. Therefore, a restriction on short selling activities will significantly decrease their ability to incorporate their views in the stock price. As a result, the stock price will reflect the views of optimistic investors only, potentially creating an unsustainable price bubble.
GameStop's share price has experienced large swings in recent months. If short sellers are unable to borrow and short the company's stock, there is a possibility that the price level only reflects the opinion of bullish investors. Therefore, the share price can be artificially inflated. Only time will tell whether the current price level is justified or not. Still, we certainly need some short sellers to ensure prices are close to the fundamental value, reflecting both optimists' and pessimists' views.
There is always a concern that short sellers may not be investing based on fundamental information; instead, they may be trying to manipulate the stock price through their trading. Such manipulative short selling is undoubtedly harmful to the markets. We need better regulation to curb manipulative practices. But, as a whole, there is a lot to gain from short sellers in a vibrant capital market.
"Short" - Google News
March 30, 2021 at 05:00PM
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Bright Side Of Short Selling: GameStop, Tesla, And Beyond - Forbes
"Short" - Google News
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