Short Sellers - how you can learn from the best stock pickers of all
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.
Disclaimer
This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
11 comments
Its a good article. Euroclear is a source of Stock on Loan data - but it does not cut the mustard unless you can re-process it into an acceptable format - and for individuals the cost is also prohibitive. As an add on here it would work well.
I read Predatory trading and crowded exits earlier in the year and the opportunity to find those potential short squeezes would be of interest as would other aspect of stock loan data - e.g. which company has recently seen an increase/decrease in short interest.
On the reverse side e.g. one OIL share I now track there was a massive capitulation in price following a duster. The stock on loan figures hardly budged - what no shorting?! Of course there was - which probably meant the stock was loaned NOT via Euroclear - especially given that the total volume of shares that changed hands in a small matter of time was greater than the stock issued by the company. Given the institutional ownership was low then how did the bigger traders pull off this massive exchange of wealth - from £400M to now £36M .....the point is Euroclear Data as a source for stock on loan is good - but it needs to be supplemented with other data which will be difficult to get. Stock on loan is a proxy for short interest - but there are other reasons.
The Bronte Capital blog is worth reading to get an idea of short strategies. John Hempton says something along the lines of they almost never short based on valuation alone because a ridiculous valuation can always become a ludicrous valuation, they prefer to seek out stock frauds and promotes where there will eventually be a catalyst for correction.
In the same way that stock market bubbles usually have their roots in a real events (the internet really did change our lives just the benefits went to the consumer not the dotcoms) I think a number of shorts become macro stories - e.g. the UK high street is dead - rather than individual company analysis. So the high short interest doesn't worry me in Home Retail (LON:HOME) with it's strong balance sheet and great cashflow whereas it would in a cheap looking company with large debts/negative cashflow.
That said, negative cashflow isn't always a sign of a good short because it means they have to regularly raise cash and if something like Ocado (LON:OCDO) earns nice placing fees for the IB's they are unlikely to put out negative recommendations on it! The time to short is probably when such companies start to struggle to get their placings away without a big discount and the investment cycle looks like it's about to turn. Easier said than done though!
At the end of last year, The Globe and Mail published an article, stating: "Going back over the last decade, buying heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28 per cent each and every year. ... market cap matters a lot – short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same strategy was used." http://is.gd/CfG1gX
In August, I posted the results of combining high short positions with momentum (http://is.gd/TgV0qC), and the reulsts looked quite encouraging. In the new year, I intend to do a follow-up on a batch of new picks.
There's a really interesting paper here about how to use Short Interest to trade against broker recommendations.
A portfolio selling high short interest / high broker buys & buying the opposite makes a 13% annual return.
The simple rule of thumb is that short interest trumps broker recommendations. If broker consensus is to buy, but the short sellers disagree - then (in general) it's best to side with the shorts. Similarly, in cases where the City has a sell recommendation on a stock but nobody is shorting, then it may be time to be contrarian.
Hi,
Interesting article Ben.
I'm excited about the Add-On for ownership information & short interest, etc.. That will nicely plug a gap in the information currently available on the site.
I agree with you that considering the reasons why a stock is being heavily shorted is an important thing to do if one is holding a decent sized position in a company. I tracked the short interest & how it moved, when I was long of Home Retail (LON:HOME) and Trinity Mirror (LON:TNI) last year - both of which seemed to move up more quickly than other stocks, caused presumably by forced buying by bear squeezes - i.e. when there is some good news issued by a company with a high short interest, then it not only pulls in usual buyers for the stock, but the buying is amplified by shorters being forced to cover their positions too - the result being much more rapid moves upwards - something that enhances returns for value investors, providing you've got your research right.
Looking forward to trying out the new features!
Cheers, Paul.
I'd be concerned that playing in equities with heavy short interest means becoming accustomed to some fairly bracing volatility. Most PI's find that takes its toll on their mental well being , often to the extent that it clouds their ( OK I'll come clean "my"..) ability to make rational decisions. And that is with a teensy trading position too!
Cheers
Some of the most heavily shorted stocks have been the biggest winners over the past 1 year (many retail names have been heavily shorted for example) Ocado, WH Smiths, Dixons. Others like Nanoco have made impressive advances whilst also being at the top of the shorters list. Hence this is far from being a simple relationship, since shorters sometimes need to cover in a rising market, they add to the list of buyers.
There are some very high profile cases where short sellers get it very wrong - Ocado, WH Smith being clearly a few of them. But just because there are some high profile cases where they get burned doesn't mean that short sellers have a general propensity to get shorting wrong.
Quite the contrary. The statistics do actually show that stocks with heavy short interest underperform the stock market - in aggregate/on average of course. There are reams of academic studies that illustrate the fact - so it's just another good factor to have in the locker when assessing the relative upside of a share - is it heavily shorted or not? Generally buying heavily shorted shares (all other things being equal) isn't a prudent strategy. Unless you went long Ocado at under £1 of course ;-)
It's also worth scanning to see which kind of hedge fund is shorting a share. The Quant/Statistical hedge funds (e.g. AQR) tend to short indiscriminately based upon e.g. high valuations. It's probably better to follow the smart fundamental/qualitative sellers in these special situations.
Ben, a thought-provoking article.
Curious though from where you get the impression of 'highly regarded stock picking abilities of these specialist investors' - exactly who holds them in high regard?
I'd equally challenge that they are successful in the long term - you only need to look at the number of hedge funds that have gone bust over the past few years to demonstrate that very few are consistently successful.
Do you think that just because a share is shorted, it should be dumped from your portfolio? Private investors have a key advantage over institutional investors (and hedge funds) in that we're not rated according to our quarterly returns, we don't suffer funds outflows if we have a bad run, and we can hold positions for the longer-term (assuming you're an investor rather than a trader). We don't have to sell or buy anything to maintain allocation percentages.
So if you own a share that short-sellers target for a quick return, it can be profitable to take advantage of the markdown to pick up stock on the cheap.
Of course, it's key to identify whether the shorters are in there because of a temporary bump in the company's fortunes which they aim to take advantage of, or whether there's something more fundamentally wrong.
Great news on the new impending functionality - can you give any further info on the new 'Ownership' add-on?
Cisk - we'll be releasing further details about the ownership package in due course. It's a combination of Thomson Reuters ownership data, short selling data, due diligence data on Officers & Directors and director trades. It's a pretty big project we are working on but hopefully it will be extremely additive. We're also going to be scoring companies quite heavily across various ranking metrics, which will all be a part of it. It should work as an add-on to the Stock Reports and Screener in general. Stay posted on the mailing list and we'll give more info as we get closer to the launch date - which at the moment is likely to be next month.
Hi Cisk,
I absolutely take your points. I think the thing about short sellers (or some of them) being held in high regard is really to do with who the main players are. Those with the largest numbers of positions are the likes of BlackRock, Lansdowne and Odey, who all have decent track records with long/short funds. By that I mean they’re pretty successful long and short; shorting worked wonders in 2008 but was a nightmare in 2011, etc.
So I guess the overall point is: what are they seeing in some of these short picks? I wouldn’t say dump a stock that’s being shorted, but it’s perhaps a signal that something may be amiss or, at the very least, somebody thinks it’s overvalued - Why? Plainly, that’s not always going to work… Ocado, WHSmith, Home Retail (in the recent past ASOS)... they’ve gone in completely the opposite direction. But as a broad point - and in the armory of tools to get informed - I think it’s worth exploring why a short seller might be in there, whether it’s, as you say, for a quick return or because there is a longer term fundamental weakness.
Cheers, Ben