For many investors, the idea of short selling shares not only raises questions about how the mechanics of such trading actually works but also conjures the unpalatable prospect of sustaining heavy losses should it all go wrong. But that doesn’t mean it’s a bad thing to study companies in the market that have the dubious honour of having high levels of ‘short interest’. In fact, because short sellers tend to be very, very smart investors, examining their trades can provide a crucial insight into which shares you probably ought to dump from your portfolio.
Short selling as an indicator
With the exception of the occasional headline in the financial press, the strategies that drive the short selling activities of boutique hedge funds and large investment banks are generally not well known. But research suggests that these smart money managers are some of the most informed investors around, skilled at processing information and adept at identifying future events that will negatively impact on share prices. After all, borrowing stock from an institutional holder (via a broker) and then selling it in the market with the expectation that its value will fall, is one that comes with theoretically limitless financial risk. If the stock actually rises and the trade has to be reversed, the short seller may need deep pockets, a strong appetite for risk and a potentially long investment horizon before the bet comes good - clearly this isn’t a game for widows and orphans!
Unsurprisingly, academics have spent years examining the impact of short selling and many agree that an anomaly exists whereby heavily shorted stocks often fall in price. Not only that, but a stock that is being short sold can act like a magnet to other short sellers, who join the trade and push the price down further. Researchers have concluded that this anomaly is driven by a perception among other investors that short sellers are actually rather good stock pickers.
Finding short interest
But while an anomaly plainly exists, any investor wanting to act on it needs to do their homework to properly understand which shares have the highest levels of short interest. Unfortunately, simply perusing the FCA’s regularly updated list of short selling positions won’t cut it. Not only is it necessary to identify high percentage short interests, but investors also need to put that in the context of shares outstanding in a given company and how expensive it is for short sellers to borrow that stock to sell on.
In 2011, analysts at Thomson Reuters introduced what they called the StarMine short interest model that takes a more holistic view of measuring short interest. It ranks stocks in the market according to the number of shares sold short and the number of shares outstanding but also looks at the overall level of institutional ownership in each stock. This institutional ownership element is vital because it’s used as a proxy for the likely amount of shares that are available for short sellers to ‘borrow’. Among the cogs and springs that make the short selling process work, brokers typically use institutional shares to lend out and set their charges according to the level of supply. As a result, where institutional ownership is comparatively low, and supply is limited, hedge funds that want to short the stock will have to pay a higher price to borrow the stock, which reduces the margins on their expected gains. Thus selling these stocks requires a much greater confidence that the stock is a dud. For any investor using short selling as a signal, it’s therefore essential to not only screen the market for short interest positions but also take account of the level of conviction behind those trades.
The StarMine model also smooths out a few idiosyncrasies that crop up with short selling, including whether there are any merger impacts and any dividend distribution effects. In the case of proposed mergers, short sellers can often take long and short positions in target and purchasing companies with the aim of making a profit on both sides of the trade. In the case of dividends, short sellers are technically on the hook for making dividend payments on stock they have sold in the market, which means they often temporarily cover their positions during dividend payment periods. In both of these cases the results can skew the real picture of where high levels of short interest really lie.
If this all sounds rather complex, fear not… in the coming weeks we at Stockopedia will be introducing our own Short Interest Rank to help investors get a detailed insight into which stocks are being short sold and which are likely to be high probability downside bets. This is to be part of our upcoming ‘Ownership’ add-on which will also incorporate Insider and Institutional trading activity on a pan-European basis. If you want to be one of the first to on the list to test out this new feature - please sign up here.
Can following short sellers be profitable?
There is no shortage of research backing the theory that following the lead of short sellers can be profitable. In the case of the StarMine model, which was tracked on US exchanges between 2004 and 2010, it generated annualised absolute returns of 13% on equal weighted long/short deciles. For long only investors (i.e. most of us who buy and hold), the relevance of these findings - and of the fact that stocks with high levels of short interest often fall in price - is that there’s something to learn from the red flags that short sellers wave. Given the highly regarded stock picking abilities of these specialist investors, getting an accurate view of which stocks have high and low (or no) levels of short interest is a significant indicator about what to avoid.
Filed Under: Short Selling,