Explanation of Short Selling and Profitable Hedge Funds

What is Short Selling?

Short selling is a complex investment strategy that operates by borrowing shares, selling them, repurchasing them at a decreased cost, and capitalizing on the price differential. However, it’s a risky strategy as short sellers stand to lose money if the stock price rises instead of falls.

The majority of short selling is performed by hedge funds and institutional investors. These entities typically use short selling to safeguard their investments against a downturn in stock prices or as a speculative maneuver when they believe a stock is overvalued.

Devalue Corporate Stock for Profit

On the other hand, there’s a subset of short sellers known as ‘activist shorts,’ exemplified by entities like Hindenburg Research. These short sellers investigate companies and pinpoint those they believe are employing questionable business or accounting practices. They then share their findings (often anonymously) to devalue the company’s stock. While activist short selling has been occurring for many years, the advent of social media has amplified its influence and audience reach.

One prominent case of short selling was led by Hindenburg Research against Block Inc., the digital payments company formerly known as Square Inc. co-founded by Jack Dorsey. Hindenburg placed a bet against the stock, alleging that Block’s Cash App facilitated fraudulent activities during the Covid-19 stimulus programs.

They also accused Block of inflating user numbers for Cash App and criticized their acquisition of Afterpay, an Australian fintech firm. These allegations caused Block’s share prices to drop significantly. Block did not publicly respond to Hindenburg’s claims.

Legality of Short Selling

Though short selling may sound dubious, it’s legal in most of the major stock markets. However, a specific type of short selling, known as ‘naked short selling’—which involves betting on a stock’s decline without first borrowing the shares—is either partially or fully banned in several markets. Additionally, during periods of market instability, temporary restrictions are often placed on short selling.

This is because critics believe short sellers can escalate market downturns into severe financial crises. Over the years, several countries, including the U.S., U.K., Germany, Japan, and China, have imposed restrictions on short selling. The Covid-19 pandemic triggered similar restrictions across countries like France, Spain, Italy, Belgium, Greece, Austria, and South Korea.

Activist short selling is viewed as particularly controversial. Critics like financial journalist Michael Thomas argue that these short sellers can manipulate markets by disseminating misleading information before closing their positions, a tactic known as ‘short and distort.’ However, proponents of short selling argue that the potential for misuse doesn’t mean all short selling should be discredited. They view themselves as market skeptics, identifying overpricing or fraudulent activities overlooked by analysts, auditors, and other investors.

Despite this, many authorities and financial institutions hold a dim view of short selling. Even a former head of the New York Stock Exchange referred to the practice as ‘icky and un-American.’

History of Short Selling

Short selling is a historical financial strategy dating back centuries. As early as the 1600s, Dutch traders practiced short selling during infamous speculative bubbles like the tulip mania. Napoleon even denounced short sellers dealing in government securities as ‘traitors.’ However, short selling stocks introduces unique challenges given that stock markets tend to climb over the long term.

This strategy has been employed successfully despite these challenges. For instance, Jesse Livermore, a legendary investor also known as the ‘King of the Bears,’ used short selling to accumulate substantial wealth by betting against the Union Pacific railroad company just before the San Francisco earthquake in 1906.

A significant victory for short sellers came with the fall of Enron Corp. in 2001. Notably, investor Jim Chanos was among the first to question the company’s accounting practices, casting doubts which eventually led to Enron’s downfall.

The current generation of activist short sellers have also made their mark. Carson Block, the founder of Muddy Waters (unrelated to Block Inc.), has been a prominent figure in this space along with Michael Lauer and Michael Burry.

Mr. Waters targeted obscure Chinese firms listed in North America, thereby enhancing the visibility of activist short selling. However, this aggressive investment strategy can invite dangerous consequences. Block confessed to halting short selling Chinese firms for some time after facing threats from “tattooed gangsters.”

As per experts, despite its historical roots and some notable successes, short selling remains a high-risk strategy, particularly given the general upward trajectory of the stock market and potential backlash from targeted companies. It is crucial for investors to weigh these factors before deciding to short sell.