Short Sellers - how you can learn from the best stock pickers of all

Monday, Oct 07 2013 by
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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…

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11 Comments on this Article show/hide all

Cisk 7th Oct '13 1 of 11
1

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?

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rick 7th Oct '13 2 of 11
2

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.

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Edward Croft 7th Oct '13 3 of 11
2

In reply to post #77890

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.

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Edward Croft 7th Oct '13 4 of 11

In reply to post #77886

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.

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Ben Hobson 7th Oct '13 5 of 11
3

In reply to post #77886

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

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rhomboid1 7th Oct '13 6 of 11

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

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Paul Scott 7th Oct '13 7 of 11
1

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.

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Mark Carter 9th Oct '13 8 of 11
1

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.

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Edward Croft 13th Oct '13 9 of 11
1

In reply to post #77991

There's a really interesting paper here about how to use Short Interest to trade against broker recommendations. 

In sum, we find that combining investment signals from analysts and short sellers yields incrementally greater future returns than trading strategies that use only one of the signals.....the most profitable investment strategy is when an investor trades in firms about which analysts and short sellers strongly disagree, and the investor takes the buy or sell position indicated by the short interest signal.

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.

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dangersimpson 14th Oct '13 10 of 11
1

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!

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Square Mile Junky 30th Dec '13 11 of 11
1

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.

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