Last week, The New Yorker published an article by James Surowiecki called In Praise of Short Sellers. The title is a bit misleading, since the article focuses on activist short sellers rather than short sellers in general. The tone is laudatory: while short selling is often criticized, activist shorts are actually a good thing because they counter "Wall Street’s inherent bullish bias," play "a vital role in uncovering malfeasance," and "contribute to the diversity of opinion that healthy markets require."
I have a more skeptical opinion of activist shorting. I don't think it's inherently bad, but neither do I think one can generalize about it the way Surowiecki does. Activist short sellers have been financially successful and have uncovered numerous frauds in the past few years, but there's no guarantee they will be successful or beneficial in the future.
Activist shorting, as it's practiced today, has a few potential flaws:
1. There's an inherent conflict of interest. Activist shorts make money when the stocks they target go down, and this gives them an incentive to exaggerate their targets' problems. Having hyperbolic bearish opinions in addition to hyperbolic bullish opinions doesn't make the market more efficient. It just means there's twice as much misinformation.
2. Over the past few years, activist short sellers have had a high batting average and have exposed dozens of Chinese reverse-merger frauds. Their success has trained investors to assume that allegations of fraud are correct until they're disproved. This allows Batesian mimics to free ride off the success of past activists by making specious accusations of fraud.
3. The Chinese reverse-merger companies were unique in how completely, pervasively fraudulent they were. Exposing them brought a lot of activist shorts to prominence and increased the amount of money that activist shorts have to invest, but now that most of the Chinese frauds have been busted, there's a much larger pool of money/talent chasing fewer frauds.
4. Many investors piggyback on activist short sellers, raising the cost to borrow shares of activist targets.
Examples of bad activist shorting
John Hempton argues that Geoinvesting's report on Amtrust is full of serious errors.
A Gotham City Research report accused Blucora of distributing malware and facilitating Internet searches for child pornography. Neither accusation was true, but Blucora stock fell sharply the day after Gotham released its report.
Kerrisdale Capital called Globalstar "The Most Egregious $4 Billion Stock Promotion Since Sino-Forest." Sino-Forest was an arrant fraud that stole hundreds of millions of dollars from investors. By contrast, Globalstar's controlling investor has poured money into the company. Globalstar may have a flawed business plan, but it has nothing in common with Sino-Forest.
Barry Minkow's Fraud Discovery Institute accused Lennar of cheating its joint-venture partners and running a Ponzi scheme. The accusations were false and were part of an effort to extort money from the company. Minkow later pleaded guilty to conspiracy to commit securities fraud and went to prison.
• Lumber Liquidators
At Whitney Tilson's suggestion, 60 Minutes investigated Lumber Liquidators. The television show later claimed that some of the company's products have harmful, illegal levels of formaldehyde. Since then, this claim has effectively been refuted-- see articles from Citron Research, "Max Vision," and The Motley Fool. I don't think Tilson intended to smear Lumber Liquidators when he approached 60 Minutes, but after the show aired and the company responded, he dug in and repeated misleading statements about its products.
Notably, Geoinvesting, Gotham City, and Kerrisdale have done good research on other companies. Geoinvesting and Kerrisdale have exposed Chinese frauds; Gotham City's research brought down a Spanish fraud called Let's Gowex. Being right on one company doesn't guarantee that an activist short will do quality work on others.
"Only shady companies attack shorts"
Surowiecki ends his article by repeating the popular belief that companies don't criticize short sellers unless they have something to hide:
Of course, short sellers are often wrong, and that may yet prove to be the case with Lumber Liquidators. But the fact that the company’s response to the charges was to attack short sellers should give investors pause. In a 2004 study, Owen Lamont, a business-school professor, looked at more than two hundred and fifty companies that had gone after short sellers—filing lawsuits, calling for S.E.C. investigations, and so on. Their long-term performance was dismal: over three years, their average stock-market return was negative forty-two per cent. That suggests that, if you react to bad news by shooting the messenger, it may be because you know the message is true.
This is less meaningful than it sounds.
Nearly all of the companies in Lamont's study were speculative companies with questionable prospects. Many were outright frauds. It wasn't the act of retaliating against short sellers that made their stocks go down, but the fact that their retaliation was symptomatic of much deeper problems. Lumber Liquidators is a real business with a history of profits. Apart from criticizing short sellers, it has nothing in common with Lamont's losers.
And Lumber Liquidators actually has a good reason to criticize the shorts. As a retailer, it depends on its customers' trust to stay in business. The claims that 60 Minutes made about the company didn't just temporarily hurt its stock price, it arguably caused lasting damage to the business itself.
Activist shorts aren't necessarily wrong, but they aren't necessarily right either. Investors should judge activist short claims individually and avoid generalizations about how short sellers are doing a public service or only guilty companies attack their critics.