Buying shares is a really simple process, but buying smart is much harder. As we’ve seen in recent articles, one way to ensure you avoid stocks that have a high probability of underperforming is to look at how many of their shares are currently being shorted. But to really avoid the worst of them, it’s vital to look at how the level of institutional ownership impacts on the supply of those shares to short sellers. By owning a heavily shorted stock with low institutional ownership, investors can be exposed to a particularly risky situation that will very possibly end in tears. Understanding this balance of interests is crucial, regardless of whether you’re long or short.
In earlier short selling articles we’ve looked at how short interest - or the percentage of a company’s shares sold short in relation to the total number of shares outstanding - is a gauge of short selling sentiment. However, short interest really only tells you one side of the story, and that’s how much demand there is to short the stock. It takes no account of the actual supply of shares available to short, which is generally measured by the level of institutional ownership. This is because short sellers typically ‘borrow’ stock from institutional holders (via a broker) - and the fewer there are the tighter the supply of available shares will often be.
What are the signs that a stock could be in trouble?
A wide range of research into the relationship between these supply and demand factors has shown that share prices become particularly vulnerable to a fall when very high short interest combines with low institutional ownership. These so-called ‘short constrained’ shares often require strong conviction on the part of short sellers, who face potentially higher trading costs (in the form of borow rates) than they would otherwise encounter in stocks with higher institutional ownership. Analysis by Asquith et al. of US shares over the period 1988-2002 found that the very highest constrained shares underperformed by a significant 215 basis points per month on an equally weighted basis. They found that this underperformance was focused on a relatively small number of heavily shorted small-cap stocks and that the period of underperformance was fairly brief.
Who can profit from ‘short constrained’ shares?
For short sellers looking for opportunities, the research suggests that trading the right constrained stocks can be…
