A short seller is someone who expects a company’s stock price to decline in the near term, and who acts on this presentiment by selling borrowed stock with the expectation of earning a profit by buying back the stock at a lower price on a later date. In this article, we explore how the short seller operates and how to most effectively deal with him.
The basic short selling process involves a three-step trading strategy. First, the short seller borrows the targeted company’s stock, usually from a broker. Second, the short seller sells the shares on the open market. Third, the short seller waits for the stock price to (hopefully) decline, and then repurchases the shares (known as “short covering”) and returns them to the lender. Short covering can increase the stock price, especially when many short sellers are repurchasing stock at the same time. Assuming that the share repurchase price was less than the initial sale price, the short seller pockets the difference as a profit.
Short selling is an extremely risky activity, since there is a potential for unlimited losses if the stock price goes up instead of down. For example, if an investor sells stock when the price is $10, the maximum possible profit on a short sell is $10 (and only if the price craters to $0); however, if the stock price jumps to $50, the investor must buy back at the higher price, resulting in a loss of $40. Given this high level of risk, investors will rarely sell short unless they feel strongly that a stock’s price has topped out.
Because of the high level of risk, short sellers like to slam a company’s prospects as publicly as possible, thereby influencing other investors to sell their shares, which in turn lowers the stock price. A favorite forum for short sellers is the Internet investment message board, on which they can anonymously post messages that anyone visiting the site can read. They may also post messages using multiple aliases, so that an innocent visitor to a message board may think that a large number of investors are all selling their holdings in a targeted stock. When a major short selling attack is going on, short sellers can effectively take over message boards with an extremely high volume of message traffic. Major investment message boards are located on the Motley Fool, Yahoo, and Raging Bull web sites.
If an investor finds that a negative publicity campaign does not work, and the stock rises instead, then the customary reaction is to reduce losses by quickly buying shares to cover their short positions. If there are many short sellers, this sudden buying frenzy will drive up the stock price even more, thereby forcing any remaining holdout short sellers to buy even more shares to cover their positions. This “short squeeze” phenomenon is especially common with stocks whose prices are highly volatile.
One special scenario is the monitoring of the restricted stock holdings of company investors by short sellers. Restricted stock can be sold after one year under SEC Rule 144. Since the timing of restriction cancellations and the amounts of restricted stock holdings are public knowledge, it is an easy matter for short sellers to anticipate the sale of large stock holdings, which should reduce the price of the stock when they are dumped on the market. The classic short selling strategy in this situation is to sell shares at a higher price just prior to the restricted stock becoming available for sale, and then buying offsetting shares after the now unrestricted stock has been sold, when prices are presumably lower.
A common reaction by a CEO who sees short selling activity is to attempt to force them out of their short positions by publicly issuing guidance of better-than-expected results. This type of publicity may increase the stock price in the very short term, creating a short squeeze that drives away short sellers. However, the more aggressive guidance also makes it more difficult to meet investor expectations, which thereby attracts even more short sellers as the CEO gradually paints the company into a “performance corner.” It eventually becomes impossible to meet the company’s own increased guidance, so that reported earnings are bound to fall below the enhanced expectations of investors. The result is a stock price decline, allowing short sellers to reap profits that were very nearly guaranteed by the CEO’s own actions to drive them away.
There are several effective methods for dealing with short sellers. First and most important, do not issue aggressive earnings guidance – ever. By issuing aggressive guidance, investor expectations are raised to heights that are difficult to sustain, resulting in increased stock price volatility and the arrival of short sellers. Instead, issue only conservative guidance which the company can comfortably meet on a long-term basis. This approach flattens stock price volatility, which keeps short sellers away.
It also pays to be proactive in dealing with short sellers by monitoring the larger message boards for sudden increases in activity concerning the company. These activity surges usually coincide with actual short sales, which are reported by the stock exchanges, and which are conveniently posted on www.shortsqueeze.com. Thus, an efficient approach to monitoring short sales is to review the shortsqueeze.com site each day to track short selling volume, and then start reviewing the message boards as soon as there is a jump in reported short selling volume. Another source of information is well-connected investors, who may hear rumors before anyone in the company. By maintaining good relations with these investors, they will be more likely to forward any information they hear. In either case, the CFO may elect to counteract the rumors by issuing statements that address the allegations being made.
At the first sign of trouble at a company, short sellers tend to circle like sharks, assuming that more bad news will follow. To avoid this issue, it is better to fully disclose every aspect of a bad news item at once, rather than dribbling it out over a long period of time. By doing so, the stock will probably suffer a single, sharp price drop to a new level that is not attractive to short sellers. Otherwise, short sellers will feast on each successive negative piece of news to reach the market, allowing them to reap profits from continuing declines in the stock price.
Short sellers may pose questions during conference calls, partially to probe for information that strengthens their case, and partially to lead management into an argument that will cast the company in a negative light. If such questions arise, state the counter-argument in a simple and straight-forward manner, and move on to the next question as rapidly as possible. It rarely makes sense to give a short seller credence by making an interminable response that seems to give weight to the question. Under no circumstances should the question-and-answer exchange grow heated.
Though unusual, it may be possible to open a line of communication with short sellers to hear the reasons why they are selling short. This is not usually necessary, since short sellers are likely to sprinkle their opinions all over the investment message boards, where the CFO can easily access them. When this information is available, consider including a statement in the next news release or conference call that offers a countervailing argument. This statement should be based on a heavy proportion of facts, rather than opinions. Under no circumstances should the statement mention any short selling activity. Instead, take the position that the company is merely presenting additional information to the marketplace, which it can interpret in any way it chooses.
Finally, the CFO can create a list of pre-set responses to a variety of worst-case scenarios that can be quickly rolled out through press releases. For example, there may be boilerplate responses to a product recall, patent litigation, loss of a customer, or the departure of a key executive. By having canned responses available, the management team will spend far less time mulling over the appropriate response, resulting in the appearance of a management team that responds quickly and well to a crisis. This obviously competent response to crises tends to result in less stock volatility, and so keeps short sellers at bay.
The advice in this article has focused on monitoring short seller activity, addressing their concerns in a calm and measured manner, and providing conservative earnings guidance. A simpler approach to short sellers is to not even consider them a problem, and to ignore them. After all, they can be viewed as providing a public service, since they reduce stock volatility by keeping stock prices from going too high; also, they keep prices from dropping too low when they close out their positions with stock purchases, which tend to increase stock prices. Thus, both active and passive approaches to short sellers can be appropriate. Only an aggressive attitude plays fully into their hands.