LAST OF A DYING BREED
Short Sellers Are Going Extinct
April 13, 2021
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REDEMPTIONS AND INHOSPITABLE CONDITIONS
We’ve previously discussed at length how the current market environment is inhospitable to short sellers, and a recent Institutional Investor article further reinforces our belief. It’s a pretty short read but we’ll provide some key excerpts below to save you the click or in case the URL changes in the future.
“Jim Chanos’ Kynikos Associates and Jim Carruthers’ Sophos Capital — both of which started 2020 with around $1 billion in regulatory assets — ended the year a shadow of their former selves.
Chanos, arguably the most well-known short seller in the world, lost more than 50 percent of its assets last year. Kynikos ended 2020 with about $405 million in regulatory assets under management, down from around $932 million the prior year, according to annual ADV filings with the Securities and Exchange Commission.
The long bull market has punished Chanos for years. In 2018, when Institutional Investor profiled him, Kynikos ran just under $2 billion, having already lost almost three-quarters of his assets since the financial crash of 2008, when it ran $7 billion.
Sophos had an even more dramatic decline than Kynikos. The firm started 2020 as the world’s largest short seller with $1.16 billion in regulatory assets under management. But by year end, the firm was winding down some positions and scaling back, as Institutional Investor previously reported. Sophos ended 2020 with $258 million, according to its ADV.
Jim Chanos and Jim Carruthers are two of the most decorated short sellers in the investment community. Short sellers in general have had a rough time since the financial crisis and a (supposed) mass exodus from Kynikos and Sophos confirms those still willing to short stocks for fundamental reasons are the last of a dying breed. Admittedly, we have been cautious in building our short book as well.
FOR BETTER OR WORSE?
The question is this – are financial markets better or worse off if nobody is willing to short stocks? Contrary to popular belief, most short selling activities are not short-and-distort campaigns, and we cannot think of one instance where a legitimate business was ruined by short sellers. Feel free to email us an example and we will gladly correct the record.
Corporations, sell-side analysts, and shareholders typically accuse short sellers of yelling fire in a crowded theatre regardless of merit. In reality, targets of short reports are usually engaged in unethical business practices or aggressive accounting. Even worse, sometimes these businesses are selling harmful products/services detrimental to society. We believe short reports should be subject to regulatory scrutiny if any content is misleading or untrue, and the author should be subject to legal liability in those instances. But accurate and well-researched reports are warning movie-goers after you smell smoke and feel inexplicably hot.
DETECTIVES AND ARCHEOLOGISTS
It is said that short sellers are the detectives and regulators are the archeologists. For the life of me, I can’t remember where I heard that quote, but it has always stuck with me. Regulatory agencies never want to be the reason investors lose money and are reluctant to be the negative catalyst that unravels a rising stock price. Rather, they show up after a collapse to point fingers and assign blame. Prosecution is reserved for only the most egregious type of fraud or if there is public interest in the case. It’s rare, but it can happen.
Said differently, short sellers warn investors on the way up and regulators confirm wrongdoing only after the house of cards has come tumbling down and the dust settles. Frauds such as Enron, Worldcom, and Tyco are perfect examples. I believe Jim Chanos was involved in uncovering all three. Regulators were warned but little action was taken until the stocks were left for dead. Without naming names, we can think of many companies with a few hundred million and even multi-billion-dollar market caps that would be considered fraudulent today. A permissive regulatory environment combined with gun-shy short sellers provides fertile soil for scams.
BURDERN OF PROOF AND INCREASED CONVICTION
In our experience, short sellers tend to know their investments with greater detail than those with long positions. First, forming a short thesis takes unique legwork to uncover lesser-known facts/data. Long investors have the benefit of reading bullish sell-side reports, window-dressed investor presentations, and speaking with largely optimistic executives. The other reason this group tends to know their positions better is because, while their potential upside is capped, their potential downside is unlimited. The skewness works in the opposite direction so short sellers need increased conviction before betting against something.
INCREASED LIQUIDITY AND REDUCED VOLATILITY
Short sellers provide more than just additional research and early warning benefits to financial markets. They also provide liquidity and reduce price volatility. When a stock is moving higher, short sellers provide liquidity to those establishing long positions. If short sellers are correct and a stock begins to collapse, those with short positions look to take profits by covering. This group provides a bid underneath the stock price so shareholders can exit should they choose to do so. In a world without short sellers, it’s plausible that negative developments could cause exaggerated downside moves as bids are fewer and further between.
WHEN DOES A COMMUNITY BECOME A CULT?
The other thing we find troubling is the magnitude of hatred and vitriol directed towards short sellers. Andrew Left, of Citron Research, received so much backlash from his GameStop short that the firm decided to discontinue publishing research on short ideas altogether.2 The Institutional Investor article referenced above was met with gleeful market participants dancing on graves. The level of toxicity within the investment community is a sad state of affairs. For example, the Robinhood crowd, Tesla uber-bulls, and Bitcoin maximalists now resemble a cult more than anything else. Naysayers or skeptics are met with unbridled contempt.
DEVOLUTION INTO ECHO CHAMBERS
Having an open and candid discussion is necessary to facilitate effective idea exchange. This extends beyond investing. We hardly see individuals with different opinions engage in a respectful conversation with one another. It has become near impossible to understand an opposing viewpoint on any topic. Instead, bulls and bears separate themselves into echo chambers and are encouraged to resent those on the other side of the trade. Bulls disregard any key metrics or data points contrary to their thesis. This attitude is not conducive to healthy markets.
It is not an easy time to be bearish or skeptical. There are a million reasons not to like the current market environment. Central banks have flooded markets with unprecedented liquidity. Multi-trillion-dollar fiscal stimulus bills are being tacked onto already large budget deficits. Ultra-low yields have grossly distorted asset prices and have dangerously pushed investors further out the risk curve. Valuations are an afterthought, and the quality of earnings don’t matter. In fact, earnings barely matter at all. Story stocks with an enticing narrative continue to outperform boring cash flow compounders. And the pension crisis still looms somewhere in the distant future. It’s no wonder short sellers and skeptics are facing extinction.
BE CAREFUL WHAT YOU WISH FOR
There are always two sides to every trade. Vilifying short sellers out of existence may feel good today, but their disappearance would impede the market’s ability to function smoothly. The purpose they serve is becoming more important in a world dominated by rules-based and passive investing. Short sellers are decreasingly participating in the markets at a time when the benefits they provide are increasingly needed.