Sprezzatura

I was recently interviewed for a thesis on short selling

Here are the questions and my answers:

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How do you view the business model used by companies like Viceroy and Muddy Waters, which is based on publishing critical analyses and short selling stocks?

I like their model. I think it’s clear and honest. Short sellers must be better than regular long-only investors because they have everything against them: short selling rules, money printing, general economic growth, the company’s propaganda apparatus, and unfortunately often also authorities and media that have negative preconceptions about short selling.

Short sellers have no reason to go after good and strong companies, as it would mean another unnecessary headwind in the business, and problems for the short selling. Short sellers must also sooner or later buy back the shares, which requires fundamental negative news to enable a repurchase without pushing up the price.

2/13. What are the biggest risks associated with short selling, and how do short sellers manage these risks?

I don’t work with short selling privately. I have only used certificates very few times to be able to short a stock or an index. Nowadays, I no longer work at any hedge fund, so I don’t short professionally either.

However, when I was a hedge fund manager at Futuris/Brummer and later at Antiloop, I managed the short selling risks by only shorting very large and liquid stocks where I normally could cover my position in a few minutes.

In addition, at Antiloop I had a rule to always have a net neutral market exposure overall, so a sudden rise in the market that pulled up short positions would be compensated by long positions rising equally. I also normally had almost twice as many but half as large short positions as long ones, so the risk of a very large rise in an individual short position was only half as large. Each short sale constituted about 1-2% of the portfolio. Even a tripling would thus only give a loss of max 5% of the portfolio.

3/13. What role do you think analysis firms like Viceroy and Muddy Waters play in maintaining market discipline and exposing misconduct in companies?

I believe that short sellers perform a very important and valuable social service. They ensure that it becomes more difficult for companies to get away with accounting fraud for example. They also ensure that stocks don’t become unreasonably expensive, which could otherwise harm the returns for passive index and pension portfolios and private individuals who buy stocks without doing a valuation.

V and M do this despite all the difficulties and risks that short selling entails. They do it moreover by clearly showing what they base their negative view on so that anyone can investigate the matter, support the information or disprove it. V and M do this without any compensation from the state or stock exchange, but only by risking their own and their clients’ capital, their time, their work and reputation on having made a correct assessment of the situation.

3b extra) When a short seller firm is wrong, it’s only the short seller who loses because all shares must be bought back – more expensively than they were sold (if the short seller is wrong). Since the short seller sells borrowed shares on the market, the short seller has made it so that there are more available shares to buy and own in the company than there actually exist. This means that more investors have had the opportunity to buy the stock, moreover cheaply, because the short seller pushes down the price. It’s an extra gift to the market and the company’s supporters. Short sellers really are a shareholder’s best friend.

4/13. There are examples of short sellers collaborating with media or analysts to spread negative rumors about companies. Where is the line between legitimate short selling and market manipulation, and how is it regulated in practice?

Short selling works in the same way as long positions, just in reverse order of Buy and Sell.

Analysts, media, company management all have greater incentives to get stocks to go up than down. Short selling is regulated much more strictly than long positions, which means that very few attempt short selling as a main strategy.

It is generally more difficult to get a price to fall than to rise, especially more than temporarily.

To answer your question directly, the boundary for manipulation goes at pure intent to influence a stock price and trade in the market in direct connection with the price reaction. Just like with stock purchases.

It’s worse for the market’s functionality with manipulation upwards than downwards, because upwards makes all long-term buyers, e.g. pension funds, lose returns then, while manipulation downwards makes all long-term stock buyers achieve higher returns.

5. How do you think future regulations, such as shorter reporting windows for short positions or more transparency requirements, would affect the market and the actors who use short selling?

Unfortunately, it would probably make the market less efficient and can lead to increased volatility, with first inflated valuations due to fewer short vigilantes keeping prices reasonable, followed by sharp downturns when reality catches up.

The best would be if short selling and long positions were treated completely equally, since all stock purchases of course also simultaneously have a seller on the other side. And all sellers have a buyer.

The largest sustained negative price effect occurs when a large, long-term shareholder sells their shares and then flags for this, as opposed to when a short seller sells shares and the market knows that the short seller later must buy back an equal number of shares.

6. What factors do you think are crucial for the success of Viceroy and Muddy Waters’ business model?

Careful analysis that over time has created a history of investment cases with good returns. Sell analyses simply require better knowledge and understanding of the companies’ operations and the market’s functionality to be successful.

7. What would you say is your biggest lesson from failed short sales, where the market may have gone against your expectations? How do you adjust your strategy in these cases to avoid making the same mistakes again?

7a It’s difficult to make money on short selling, much more difficult than on owning stocks. You have almost everything and everyone against you, and only a (possibly objective) too high valuation with you as a tailwind.

7b An expensive stock can always become more expensive. It’s equally important to keep track of the stock price movements, the company’s propaganda, media coverage and trends among investors as it is to understand the company’s operations and products and make forecasts for the company’s accounts.

8. How does a short seller handle situations where analyses indicate that a stock is overvalued, but the market continues to drive the price upward? How long is one willing to wait for a decline?

It’s different for everyone and depends on what strategy you have at the bottom. I used to accept that a short position doubled before I stopped the trade. If you’re short only, the stop-loss is tighter, maybe only 25-50% increase.

9. Considering the development of AI, how do you think the technology will change short selling as a strategy? Can machine learning outperform human experience when it comes to identifying overvalued stocks?

The world’s best technical trading system is Renaissance Capital, which is built entirely on pattern analysis and where buy and sell are handled as completely equivalent transactions. However, this is trading and not short seller analyses.

AI will probably over time make more comprehensive analyses of companies’ operations and competitive situations, and make better cash flow forecasts than a human analyst. AI can probably also make better forecasts of likely valuation multiples, and continue to make better stock price forecasts supported by Cash Flow times Cash Flow Multiple plus complementary price pattern analysis, etc.

So, yes, I think AI will make both better analyses of undervalued and overvalued stocks, but it’s not likely to make either of the activities easier for either humans or AIs, just different. One can argue for both a future market with very low volatility and one with very high, for one with much fewer mispriced stocks and one with many more.

Perhaps there are slightly stronger arguments that overvalued stocks due to accounting fraud, frauds, unsustainable business models, etc. will be harder for AI to find, which in that case would make short selling a more future-proof strategy than others.

10. What market conditions and various indicators does a short seller analyze to assess whether it’s a good time to short a stock, and how does one weigh the risks of short-term price changes against the potential return in a highly volatile market?

It’s an art form, just like stock buying, only a little harder, and you have time, the market, central banks and other authorities against you. Because shorting has been seen as destabilizing and with risk of manipulation.

That short sellers have all authorities against them is because, for example, weak banks are easy targets in financial crises (and weak banks can cause system crises), but is actually not the short sellers’ fault but the authorities who inflated the financial bubble. Moreover, short sellers have a greater risk of crashing, which in itself can cause consequential problems.

And without clear regulations for how to ensure that short sales can be completed and bought back, the risks increase that short sellers cause problems for themselves, and thus also for others and for the entire financial system.

You can analyze as many variables as you want or almost none at all. There are no shortcuts or simple models.

11. In an old podcast episode of “marknaden” (the market), you mentioned different types of short selling strategies, one strategy was to be market neutral and the other is to short a stock for it to go down and you win on it. Which strategy do you think Viceroy and Muddy Waters have as they work on publishing negative reports that can lead to stock price drops for the company they short? Are they doing the market a service or do you think it’s more about the profit?

Everyone who trades stocks is in it just for the profit.

a short seller automatically does the market a greater service as a police and moderator

Just as people want freedom and security, including freedom to take risks, or security to know that they can manage even if a risk goes wrong, etc., investors want maximum risk-adjusted returns.

This applies to both short sellers and buyers to the same extent.

The interesting thing about short sellers is that they believe that despite all the difficulties, there are better risk-adjusted opportunities to make money by shorting overvalued and fraudulent companies than by finding undervalued ones.

Short sellers thus believe that the market is extra inefficient among overvalued companies. I do too. And it means that a short seller automatically does the market a greater service as a police and moderator than other investors.

12. Muddy Waters’ latest report targets Eurofins, where they accuse the company of potential fraud. Eurofins has responded strongly to the report and considers the accusations unfounded. How is a company’s stock price affected when they are accused of ‘potential fraud’ in this way, especially if the market later judges that the accusations are unfounded? How is the short seller affected if the market later reacts against the accusations and the stock price recovers? Doesn’t the short seller win anyway, even if the information turns out to be unfounded?

Everyone who buys the stock at lower prices wins by buying there. In the end, the company will eventually be valued as it always would have been anyway. Sometime in the future the revenues, profits and valuations multiples will be normal, and what they always would have reached sooner or later.

If Muddy is actually wrong in their accusations, it becomes difficult to succeed in buying back the stock before it has gone higher than they sold. It is not a sustainable strategy to try to push down a stock with pure media manipulation and buy back before the bluff is exposed. There are much easier and legal ways to make money as an investor.

13. How do you assess the credibility of Muddy Waters, especially in cases where companies they criticize have responded with strong counter-arguments and corrected information?

I’m not an expert on Muddy, but everyone can make mistakes. And I don’t know who makes the assessment that the answers have been “strong” and well-founded.