Tuesday, March 24, 2015

The limits of activist short selling

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

• Amtrust
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.


  1. I do not think the Chinese reverse mergers are uniquely fraudulent.

    I can think of other areas that are just as fraudulent.

    1. I'd be interested to hear which areas you think are equally bad. My impression is that a lot of small-caps are promotional scams-- e.g. in mining, oil and gas, or biotech-- but that the Chinese reverse mergers involved outright theft to a much greater extent than any other sector.

  2. Y0ungmoney: Did you do any homework? You sound quite ignorant. For example:

    (1) You mention Geoinvesting/Gotham/Kerrisdale/Tilson in the same sentence as Barry Minkow. Minkow used knowably false information and blackmailed Lennar. Minkow committed crimes. Are you equating these other guys, with Minkow who knowably spread false information, and bullied Lennar?

    a. Geoinvesting's thesis on Amtrust is actually multi-pronged, may be right or wrong with time ... did you bother to read what Hempton actually wrote on Amtrust?
    b. Gotham's thesis on Blucora too, was multi-pronged... you fail to show they were wrong on the child porn related findings. You also willfully omit the other legs of their thesis (just as you did with Geoinvesting's AFSI work)

    c. Kerrisdale - fine, you may have a point on the Sino-forest comparisons, but Kerrisdale admitted to as much. Here, too, what's your basis for them being wrong?

    d. Tilson and other LL shorts - they have some good points, some bad points... again, how do you know this is an example of "bad short selling"?

    The rest of your article is similarly disappointing, and poorly researched.

    1. I didn't mention the others shorts "in the same sentence" as Minkow. I gave them as discrete examples of how activist shorts can be misleading, and the post doesn't imply that their actions are equivalent to his.

      Gotham's report on Blucora gets basic facts wrong. It refers to ccs.infospace.com as css.infospace.com. It implies that Infospace's purchases of porn-related keywords were part of a deliberate strategy rather than being alogrithmic. It barely mentions Blucora's ownership of two valuable non-search businesses. The thesis may be "multi-pronged," but that's not an advantage when all of the prongs are false.

      I think Kerrisdale is right about Globalstar, but the Sino-Forest comparison was intentionally misleading and meant to generate fear. My point here isn't to refute Kerrisdale but to say that the ends don't justify the means.

      Tilson is making sensationalistic arguments ("Lumber Liquidators is evil") and ignoring substantive points that the bulls have made.

  3. Thanks for your thoughts, but I struggle to understand the thought process behind this post. It appears that none of the issues mentioned here is unique to “activist short selling”, or even short selling in general.

    First, you mischaracterize the potential flaws of activist short selling. Your first point about conflict of interest is false. A conflict of interest arises when a person has a duty to more than one party/obligation, but fulfilling the duty to one could potentially jeopardize the interest of another. When you find problematic/fraudulent aspects of a company and you make money by shorting it, your intellectual and financial interests and motivations are perfectly aligned. The behavior you described is not so much conflict of interest, but investors being overly promotional about their positions. That is hardly limited to short selling.

    Your second and third point contradict each other. Your third point suggests that the market for shorting frauds is a lot more efficient now, given the larger pool of money and talent chasing fewer frauds. However, your second point states that some people are free riding off past successful short sellers by offering “specious accusations” of fraud, which lead the stocks to drop anyway since companies are now assumed guilty until proven otherwise. A more efficient market is not one that allows you to make easy money by free riding off others. If your third point is true, then most frauds should have already been exposed, and people who just throw groundless accusations at non-fraudulent companies would be proven as such in time. The impact of their calls would diminish, as would their financial gains. The scenario in which one can consistently make money by making false accusations simply doesn’t exist. If short sellers enjoy sustained alpha over time, then the market is not as efficient as you think, and their claims are not as exaggerated as you believe.

    On investors piggybacking activist short sellers and causing the cost of borrow to increase. Again, while this true, how is this limited to short selling? When investors piggyback off long ideas from any famous fund manager, do they not cause the cost basis to go up?

    On your examples of bad activist short selling: I can easily come up with lists such as “spinoffs gone bad”, “macro shorts that ripped your face off”, “merger arbitrage trades that blew up funds”, etc. Yet does any of these lists prove or illustrate that the respective strategy is fundamentally more flawed than any other investing strategy? I don’t think so.

    I think with a few tweaks, your post might as well be called “limitations of general investing”. That would be a more accurate representation.

    1. There's a conflict of interest in the sense that their reports are presented as being factual and objective, but they have a financial interest in portraying their targets as negatively as possible. If you think overly promotional is a better way of describing that, that's fine-- it's just a semantical difference.

      The second and third points aren't contradictory. Investment classes often go from being undervalued, to being efficiently priced, to being overvalued. Likewise, investing strategies can go from being obscure-- a few investors chasing after a lot of opportunities-- to being widely known-- a lot of investors chasing after a few opportunities. IMO, that's what has happened with activist shorting.

      The pendulum often swings from one extreme to the other: if a market becomes efficient, there's no guarantee it will stay that way.

      I agree that many of the arguments in this post can be applied to other investing strategies. In the past, I've made some of the same criticisms of buying spinoffs. In this case, I wrote specifically about activist shorting because I thought Surowiecki's article had an optimistic bias-- my goal wasn't to portray activist shorting as uniquely bad, but to offer counterarguments to the article.


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