Have you hugged a short-seller today?
You should. Despite their reputation as unscrupulous investors who benefit when share prices fall – and sometimes play an active role in that decline – short-sellers are your friends.
There is nothing mysterious about how they operate: They borrow shares from investors, then sell them in the hope of buying them back one day at a lower cost. Their profit comes from the difference between what they sold the shares for and what they bought them for.
It sounds simple enough, but they often run afoul of other investors and corporate managers, neither of whom likes the idea of someone profiting from bad news or disseminating it. Many people believe short-sellers mislead the market.
Even regulators go after short-sellers sometimes. During the depths of the recent financial crisis, when many stocks were in freefall, regulators in Canada, the United States, Europe and Australia put a temporary ban on at least some short-selling activity, under the belief that they contributed to the sell-off.
This attitude is misplaced though: Short-sellers provide a valuable service to the stock market.
Their most obvious role is in keeping companies on their toes by staying on the lookout for scams. Enron Corp. was brought down, in part, by short-sellers, due to concerns about the company's accounting standards. A short-seller also skewered Sino-Forest Corp. out of concerns about the company's stated assets.
Existing shareholders lost big. But the fault was with the companies, not the short-sellers – and you can hope that both cases have pushed other companies into taking a more honest approach to their finances.
Short-sellers also provide necessary skepticism in the market, which can prevent valuations from running skyward. Overvalued stocks tend to have lower future returns, and can be volatile when things go wrong. A dose of skepticism – even if it is directed against stocks you own – makes markets function better.
But perhaps the best argument in favour of short-sellers is what the market looks like without them: Academics who have studied the impact of short-selling bans in 2008 and 2009 have come to the conclusion that the bans sent markets askew.
Uwe Helmes from the Australian School of Business at the University of New South Wales and Julia Henker and Thomas Henker from Bond University in Australia looked at impact of the eight-month ban in Australia. They found that the ban reduced trading activity, increased the spread between selling and buying prices, and increased intraday volatility – none of which should be welcome news to any investor.
"We find strong evidence that stocks subject to the short sale ban in Australia suffered a severe degradation in market quality," they concluded.
Short-selling is not a suitable strategy for the average investor, of course, because the risks can be substantial. But the average investor should be pleased that short-sellers are out there.
READERS: Well, should we love or loathe short-sellers? Tell us your experiences owning stock that got shorted.