Why The World Needs Short Sellers

Short selling has a notoriously bad reputation. And yet, not only is short selling a legitimate activity, it provides a vital service to the marketplace.

Well, you broke all the records. You smashed ‘em

Last week the question was posed, “Are you interested in learning more about shorting?” Your collective answer was an aggressive “YES, I want to learn more about shorting.” More feedback came in for that single query than any other Taipan Daily piece thus far. (That’s a pretty high hurdle.)

Shorting is such a big topic, there are myriad ways to go about discussing it. What makes the most sense, your humble editor believes, is to break it up over an extended series of TD episodes. So that’s what we’ll do. First we’ll pick a good place to start. Then we’ll revisit the shorting topic on a regular basis, using it as a lens to further explore key aspects of the trading and investing game.

An Unsavory Reputation

In case you hadn’t noticed, short selling has a bit of a bad reputation. Many investors see short selling as mean-spirited, unpatriotic, or even morally wrong.

When the market is getting hammered, pundits love to beat up on the shorts. When a public company sees its stock price hit the skids, management loves to rip on the shorts too, often blaming them for the decline. Short sellers are one of the few minority groups of whom it’s still okay to slander.

On various stock message boards, it’s not uncommon to come across opinions like “I wish all shorting could be banned,” or even, “I wish the shorts would get thrown in jail.” (Ironically, the loonier the fan base, the more likely the stock in question is overvalued - and thus a potentially good short candidate.)

Would it be a good thing to ban all short selling? Would the market be a better place if stocks could only be bought “long,” and never pre-sold in advance (i.e. shorted) with the hope of buying back at a lower price?

In your editor’s opinion, “No! A thousand times no!”

Short sellers get a bum rap. Not only is short selling a legitimate activity, it provides a vital service to the marketplace. Sure, there are a few rotten apples in the barrel. But the same could be said on the bullish side. A small percentage of public companies break the law too. Does that cause anyone to question going long?

Short Sellers Are Truth Tellers

Why does the world need short sellers? There are many reasons. But perhaps the biggest one is because short sellers are truth tellers. They aren’t afraid to say the hard thing… to point out that the emperor has no clothes. This is pretty important, as we’ll soon see.

The short sellers who really know their stuff consistently do some of the best research on Wall Street. A great short seller is like a bloodhound - he (or she) develops a nose for hype, fraud and deceit. When a stock (or an industry or a market) declines, or the fraud is exposed, that detective work pays off.

One of the most famous examples of short seller detective work came in the form of Enron. Jim Chanos, perhaps the best-known short seller on Wall Street, was waving big red flags even when the rest of Wall Street still loved Enron. Bullish research analysts - whose firms were compromised by the desire to do business with the companies they covered - dismissed Chanos as a crank.

With hindsight, we now know that Enron was a disaster. Not just a financial disaster, but a human disaster. Countless employees lost everything. Retirement nest eggs built up over decades were wiped out.

Jim Chanos didn’t bring down Enron (though he made a small fortune shorting it). Fraudulent companies are ticking time bombs. Even if it takes years for the fuse to light, it’s still just a matter of time.

But think how much better off all those employees would have been, and how much better off Enron’s investors would have been, if they had paid attention to a guy like Jim Chanos earlier. They could have saved a lot of heartache and pain - or at least better protected themselves from the fallout.

Dreamers and Realists

In the world of fast-growing companies, at least two different types of leadership are required. You need dreamers and you need realists.

Without dreamers, the “grand vision” never gets implemented. Dreamers provide the boldness to tackle new problems, conquer new markets, inspire the troops to greatness and so on. Realists provide the hard-nosed perspective. They keep the dreamers from getting carried away. Without dreamers, growth companies don’t grow by leaps and bounds or reach their full potential. But without realists, those same companies quickly get untethered and become a danger to themselves.

Long-only investors are like professional dreamers. They are always looking at the “blue sky” potential… taking the optimistic outlook, walking on the sunny side of the street. This is fine, most of the time. The problem is, dreamers can get carried away - and investors can too.

We saw this in the dot-com bubble. Investors got so excited about “eyeballs” and “clicks” and “information silos” that rationality left the building. Crazy stories were spun about how cash-burning companies run by hyperactive 25-year-olds were worth triple-digit P/E multiples.

As a hard-nosed realist, the short sellers provide a service by bringing the markets back to reality. They step in and say “Hey. Guys. You’re getting a bit carried away here.”

Bubble Dampers

The dot-com bubble is also an example of what happens when short sellers aren’t allowed to do their job properly. Part of the reason tech stock valuations got so insane is because the “float” of the most popular dot-com names was so small.

At the height of the dot-com frenzy, it became almost impossible to go short (not to mention suicidal from a risk-management standpoint). So the shorts more or less stepped aside… and the result was pure pandemonium.

“So what,” you might say. “What’s the harm of a little bubble?” The harm of a bubble is that precious investment capital gets misallocated, and thus wasted. When investors allocate capital poorly, the result is missed opportunity, or even a general decline in real wealth.

Just think how much better off we’d be, for example, if investors had been more focused on the nation’s energy infrastructure 10 years back, instead of funding million-dollar Super Bowl ads for the likes of “Pets.com.”

A far more painful example is the housing bubble. Real estate prices reached truly absurd heights, in part, because you can’t go short real estate. The dreamers and the schemers took full advantage of the gullible, and valuations shot into the stratosphere.

The housing bubble fallout is truly epic. Millions of mortgage holders are “upside down”… locked into a ball-and-chain investment and deeply in debt. Economic mobility has suffered. Far too many resources were poured into the construction and real estate industries, which are now suffering from gross overcapacity. The toxic business of packaging and reselling bad mortgages turned out to be toxic for the entire planet.

Could short sellers have prevented all this? Probably not. But they certainly could have dampened the effects, had Wall Street and Washington chosen to give the “realists” more due.

It’s bad for everybody when a huge bubble pops. Even those who make money shorting the bubble have to live with the economic aftermath, and witness the suffering of friends and colleagues to boot. We would see fewer bubbles, and a better balance of optimism and common sense, if short sellers in general got more respect.

The Importance of Failure

There is another very important aspect of free market capitalism that Wall Street and Washington don’t understand. That aspect is failure.

Without failure, capitalism simply doesn’t work. As Frank Borman quipped, “Capitalism without bankruptcy is like Christianity without hell.” It just doesn’t fly.

The beauty of the free market is its natural ability to fluidly “reallocate capital,” i.e. to recover from mistakes. Capital is invested in what appears to be a productive business, with the hope of generating a positive return on investment. That positive return comes from productivity, which is good for the entire economy (i.e. good for everyone).

But if the business turns out to be a bad investment - and goes into decline or even fails - then that capital gets released and is free to flow elsewhere. Employees working in that unproductive business are freed to find more productive work. Physical assets like plants and equipment are sold off, perhaps bought by stronger, better-run companies that are succeeding and making a profit.

In this manner, a free market economy is self-healing. Nobody has to tell the capital where to flow. It goes where it is best treated and most needed. When you take failure out of the system, though, the free market is no longer free and the self-healing aspect disappears.

This is exactly what happened to Japan. The land of the rising sun has been mired in deflationary malaise for two decades because the Japanese never really grokked the importance of failure. They thought it would be okay to prop up zombie banks and walking dead institutions ad infinitum, pouring ever larger amounts of capital into dumb government-sponsored ideas like bridges to nowhere.

As a result, Japan’s economy - one of the richest in the world - has become mired in muck. In trying to prevent failure, and in permanently propping up the institutions that should have failed, Japan built the financial equivalent of a giant dam. They stopped up the free flow of investment capital and turned it into a dead, stagnant pool.

Ambassadors of Creative Destruction

In a way, then, short sellers are agents of failure in the marketplace. Actually, “ambassadors of creative destruction” is a more palatable way to phrase it. The free market needs failure, just as nature needs the cycle of death and rebirth, to stay healthy.

Short sellers encourage Mr. Market to come to terms with poor capital allocation decisions. They encourage him to set that capital free - to let it flow elsewhere, rather than keeping it dammed up in a weak or corrupt enterprise. And they encourage Mr. Market not to get too pie-eyed in the first place, keeping the “dreams and schemes” from going dangerously awry.

On top of all this, short selling can be quite lucrative work if done right. It’s a useful tool to have in one’s arsenal, depending on the market conditions at hand. To do well as a short, though, you have to be willing to buck the system… to cut against the grain of Wall Street, challenge the thrust of conventional wisdom, and stand willingly apart from your fellow investors. We’ll talk more about specifics next time around.