Cover Story: The short seller has two faces

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on February 5, 2018 - February 11, 2018.

Short sellers tell the truth. The person who points out that the emperor has no clothes shouldn’t be blamed. > Teitelbaum

Teitelbaum defends short sellers, claiming that they perform the job of regulators in the market

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Short sellers are viewed as little short of criminals. They are generally perceived as greedy and opportunistic, if not downright manipulative, selling shares they do not own in the hopes of driving down a particular stock or even a currency.

Generally, they are supposed to operate in a bearish market — when a stock or currency is overvalued and everyone is aware of it, but unwilling to do anything about it for fear of triggering a crash.

During the 1997/98 Asian financial crisis, short sellers were blamed for much of the chaos that resulted from the selldown in Southeast Asian stocks and currencies. Both the short sellers and those who lent to them came under fire and were regarded almost as traitors to the country. (Short sellers sell shares or currencies they do not have with the hope of buying them back at a lower price. To do this, they have to borrow the shares or currencies first.)

Perhaps one of the most famous short sellers at the time was George Soros, who operated the famous hedge fund, Quantum Fund. He went head-to-head with the Bank of England in 1992 when the pound sterling was known to be overvalued because it was trading within a certain range against the Deutschmark. When Soros attacked the currency, the Bank of England tried to defend it but failed. The pound sterling fell and Britain was forced out of the Exchange Rate Mechanism.

Although this was known as Black Wednesday in Britain and it cost the country about £3.3 billion, others view being forced out of the ERM as one of the best outcomes for the country. This is because the new economic policy devised in the aftermath led to the re-establishment of economic growth and falling unemployment and inflation.

In 1997, Soros was blamed for attacking the currencies in Southeast Asia, starting with the baht and later other Asian currencies, including the rupiah, ringgit, Philippine peso and even the Singapore and Hong Kong dollars — a charge he hotly denied, trading harsh words and epithets with the then prime minister Tun Dr Mahathir Mohamad.

“It (the Asian financial crisis) is known as the Asian contagion in the US. It is an interesting point to start the discussion about short sellers. It is an example of how these people tend to be associated with bad stuff and perceived as those who hurt people [to benefit themselves].

“I remember the Malaysian prime minister, among others, making very aggressive and nasty comments about George Soros [and blaming him for the economic turmoil in the country],” says former Bloomberg News senior writer Richard Teitelbaum.

In fact, Mahathir called Soros a “moron” and Soros responded by calling Mahathir a “menace”. The prime minister then banned short selling to curb capital outflows but the short sellers moved to Singapore where certain banks were offering extremely high interest rates for the ringgit, which was then lent to the short sellers. Mahathir put a stop to this by instituting capital controls in 1998, stating that all offshore ringgit would have to be repatriated within a month or it would no longer be legal tender.

The ban on short selling was only lifted in 2006.

With all this history to its credit, it is no wonder that short selling and short sellers have a bad reputation. But this may only be part of the picture, says Teitelbaum.

This is why he wrote The Most Dangerous Trade: How Short Sellers Uncover Fraud, Keep Markets Honest and Make and Lose Billions.

The book, which tells the story of 10 renowned short sellers in the US — William Ackman, Manuel P Asensio, James Chanos, David Einhorn, Carson Block, Bill Fleckenstein, Douglas Kass, David Tice, Paolo Pellegrini and Marc Cohodes — talks not only about their successes but also the risks they took, their challenges and their failures.

It aims to provide a more balanced view of short sellers, talking about how they have, in some cases, contributed positively by exposing market inefficiencies and overpriced companies or currencies.


Calling out the frauds

According to Teitelbaum, rather than spread rumours to drive down markets, many short sellers actually do their homework and delve into a company’s financials to identify anomalies. They only take short positions when they have sufficient data to justify the course.

A short seller only succeeds if other market players agree with his view and also sell their shares. Otherwise, the shares sold would be mopped up by the market and the short seller would lose money. Many a time, once the short sellers had highlighted a particular stock, the regulators investigated further.

A classic example is web portal and online service provider American Online (AOL), one of the pioneers in the internet space. Before Tech Wreck 2000, it was the darling of tech investors who pushed it up from its initial public offering price of US$11.50 in 1992 to more than US$90 by the end of 1999.

The company was wildly overpriced because of the high market demand for all things internet. When the short sellers moved in, they warned the market about AOL’s move to inflate its sales and earnings. In other words, its soaring price and sky-high valuations were unjustified.

Among its most vocal critics were Kynikos Associates founder and president Jim Chanos, who shorted Enron Corp’s shares in 2001, and Rocker Partners LP founder David Rocker.

Chanos warned that AOL had manipulated its accounts by lengthening the time over which the company’s R&D cost would be expensed. As a result, it posted sales of US$1.1 billion in the fiscal year 1996, a close to 300% increase from the year before.

Rocker pointed out that AOL was treating part of its marketing costs as capital expenditure, which is deductible from total taxable income under the US tax code. This allowed the company to inflate its earnings and present a false picture to the market.

“Short sellers were yelling but nobody listened,” says Teitelbaum.

In 2000, AOL bought Time Warner (a US-based multinational mass media and entertainment conglomerate) for 

US$162 billion, giving birth to a new entity called AOL Time Warner. Because of its very high valuation, AOL came to own 55% of the new company, although it was generating only US$4.8 billion in revenue and had 12,000 employees, compared with Time Warner’s US$26.8 billion revenue and 70,000-strong workforce.

Three months after the merger, the dotcom bubble burst and AOL Time Warner’s share price crashed from more than US$90 to US$6 in just a day, says Teitelbaum. The company was subsequently charged by the US Securities and Exchange Commission (SEC) with overstating its online advertising revenue and the number of its internet subscribers.

“The event saw an enormous disruption of capital that affected the lives of many people. I used to work for a magazine under Time Warner back then. And Time Warner’s employees participated in a retirement programme where their retirement fund was tied to the company’s stock. When the company’s share price blew up, those who were ready to retire saw a huge part of their retirement money evaporate.

“In hindsight, they [the short sellers] were right about AOL,” says Teitelbaum, adding that he had left Time Warner for Bloomberg News two years before the merger.


Should short sellers be doing the regulator’s work?

One might say the work of uncovering fraud should be left to the regulators rather than the short sellers, who short a stock to earn a profit. But Teitelbaum, who is a believer in the free-market mechanism, does not think so, at least in the context of the US.

In his view, regulators are not perfect and often face the challenge of limited resources.

Thus, the free-market mechanism that allows short selling could incentivise short sellers to provide market players with a different view, which, in turn, would help them make informed decisions.

For instance, says Teitelbaum, the SEC, which oversees market activities with the aim of protecting investor rights, has not pursued accounting fraud vigorously. “The SEC doesn’t do its job well. Part of the reason is that it hires lawyers, not traders [who know what is really happening in the market]. The staff of the SEC are not appropriate. Also, the regulator lacks the manpower to oversee the market.”

Furthermore, Jay Clayton, a US attorney and chairman of the SEC since May last year, has a controversial background, he says. “He came from a very prestigious law firm and worked on the Alibaba IPO. There are a lot of concerns about Alibaba’s accounting treatment. I’m not saying that under him, the SEC will never go after Alibaba, but there is a limitation on how regulators can oversee overall market activity. Short sellers, albeit with the motive of profiting from the market, could fill this gap.

“The more debates and intelligence that go into the market, the more intelligent the outcome will be.”

Teitelbaum also does not agree with the view that the short-selling mechanism opens doors to market speculation. On the contrary, he says, this could actually “dampen rampant speculation”.

“It often brings new information into the market and provides an incentive for market participants to uncover fraud. It helps the market trade more efficiently, aiding the process of price discovery, which means helping securities trade at an appropriate price. Capital is allocated more efficiently and everybody benefits, except speculators, fraudsters and short-sighted politicians seeking re-election.

“There are certainly people who utilise the short-selling mechanism to spread lies and rumours without providing facts and proof. This also happens in other sectors and industries. But, ultimately, I believe short selling should be allowed and it could bring more positives than negatives to the market.”

Teitelbaum adds that it is only natural to allow people to wager both ways on a stock — that it will appreciate or that it will decline.

What about Soros? Teitelbaum maintains that the same events (brought about by Soros shorting the various currencies) could have happened sooner or later. In each case, he maintains, it was just a matter of time.

“Short sellers tell the truth. The person who points out that the emperor has no clothes shouldn’t be blamed.”

After all, it is very easy for people to dislike or hate short sellers. Most market players benefit from a rise rather than a fall in share prices or currencies. It is also human nature to find someone to blame when things go wrong.

“For instance, I know the CEO of a listed tech company. He is a nice guy. He knows me too but did not know that I had published a book. Once when the stock of his company got hammered, he told me: ‘You know what, Richard, the short sellers out there are really hurting us.’”

However, Teitelbaum told the CEO that was not the case. “In fact, I told him his stock was getting hammered mainly because his company was competing with Apple. He was in a fast-moving industry and his products had not caught up with the market. I said, ‘There’s a big red target on you that tells people they shouldn’t be paying 40 times PER (price-earnings ratio) for your stock but 10 times instead.’ Frankly, if my mom wanted to invest in that stock, I would want her to wait until it is priced at 10 times (rather than 40 times) PER.”


Taking enormous risks

Lack of understanding of the enormous risk short sellers take and how much it could impact their lives is another factor that gives rise to misconceptions, says Teitelbaum.

“It’s easier to say something to increase a share price rather than the other way round. It’s not a great way of making money. It is dangerous. Among others, an example is that short sellers who shorted AOL all those years ago lost all their money in the bet. Can you imagine how it feels to see the price of a dishonest company moving up while you eventually lose all your money?”

Short selling is also risky because the cost of borrowing securities is much higher than just buying stocks from online platforms or brokers, at least in the US.

“Short sellers usually pay a very high interest rate on borrowed stocks, which amounts to 10% or so. If the stock is in high demand because of scarcity or because there are many people who want to short it, the interest rate could rise to as high as 15% to 40%,” says Teitelbaum.

According to his book, Asensio & Company, Inc, founder Manuel P Asensio once paid an interest rate of 40% based on the value of a borrowed stock.

More importantly, short sellers face a huge amount of stress in their lives as, whether they intend to or not, they always make new enemies. Investors do not like them as they do not want to see share prices or the market head south. The CEOs of targeted companies dislike them when their companies are being accused of accounting fraud. The regulators do not like them as they are perceived to be spreading false sentiment to drive down markets for their own benefit.

Often, they are the target of vulgar names and receive nasty emails and phone calls. Asensio, for instance, was often called a liar, thief and “Ass-ensio”.

Bill Fleckenstein, founder and president of Fleckenstein Capital, who made his fortune during the 2008/09 global financial crisis, received emails and anonymous phone calls labelling him a “total loser”, “pinhead” and “complete bozo”.

Even worse, Carson Block, founder of Muddy Water Research, which focuses on companies in China, “receives periodic death threats via email” and the company’s website is regularly hacked.

Asensio, among others, has been sued by various US corporations because he accused them of fraud. The litigation cost him a fortune, although the total sum is not disclosed in Teitelbaum’s book.

Often, these events take a toll on short sellers’ private lives. “Of all the guys I’ve talked to, most are divorced and blame the profession, at least partly, for ruining their marriages.

“It takes a certain type of person to be a short seller. They are usually independent thinkers and contrarians. They can stand the pain, meaning that they can be holding positions that will cost them a huge amount of money day in and day out over many years. Like now, when you see the US stock market soaring, these people are losing money.

“Of all the people I talked to, these are people who worked at big brokerage firms or investment banks at one point. But they didn’t fit in. They are passionate about the stock market and would venture out on their own. Some may have come from good families but many come from broken homes. They are interesting people. And I don’t think I can be one of them,” says Teitelbaum.


Experiencing a shake-up

Whether one likes or dislikes them, the number of short sellers has been decreasing in the US in recent years. The industry is undergoing a shake-up, says Teitelbaum.

The reason is simple. Under the quantitative easing programme launched by major central banks globally, the markets are flush with liquidity that has propped up asset prices everywhere else. Short sellers have suffered because the markets are moving up without much volatility. And they are not out of the woods yet.

According to Hedge Fund Research (an authoritative provider of hedge fund information), the number of hedge funds that focus on short selling had dropped to just 16 in the second quarter of 2017 from 54 in 2008 while assets under management had shrunk from US$7.7 billion to US$4.19 billion.

Also, average returns have been negative for these funds in the past six to seven years.

Another factor that has contributed to the decline in short sellers is the increase in passive investing, says Teitelbaum. “I don’t think the shake-up is a bad thing. Those hedge funds that adopt long-only investing strategies and charge a wildly overpriced fee are not going to survive. There used to be a whole bunch of hedge funds out there but now, only the best performers survive,” says Teitelbaum.

The US regulators, including the SEC, have not had issues with short sellers in recent years as the markets have been relatively stable or have kept rising. Occasionally, people demand that short sellers disclose their short positions to increase transparency. But this, says Teitelbaum, does not make sense.

“Short sellers do not own the stock when they take a short position. They borrow the stock and sell it. So, why would you disclose the position of a stock you don’t own? Secondly, this will certainly open them to attacks. Other market players could buy up the stocks they shorted, so they fail in their attempt [to bring down the price of the stock in question],” he points out.

Nevertheless, despite the decrease in the number of short sellers and short selling-focused hedge funds, short sellers remain relevant to the market today. Those who outperform their peers and continue to generate returns during the tough times are here to stay.

For instance, Kynikos Associate’s Chanos has continued to help institutional investors manage their money, says Teitelbaum.

Marc Cohodes, a veteran short seller, has also been active in the market. In July last year, he took a short position on Exchange Income Corp, a Canadian airline company, due to its weak fundamentals and doubtful safety record. He also disclosed his short position on Badger Daylighting — a Canadian company that is also the largest provider of non-destructive hydrovac excavation to North America — by questioning its high account receivables and business activities that harm the environment.

“Muddy Water’s Carson Block is another short seller whom investors in Asia might want to follow as he is focusing on China,” says Teitelbaum.


What is short selling?

Short selling is a way of trading securities, such as stocks, to profit from a fall in prices. By comparison, most investors long securities to profit from the rise in prices.

How does short selling work? To put it simply, a short seller “borrows” securities, say a stock, from a brokerage firm by paying the firm a commission and an interest rate over a given period of time. Then, the short seller sells the borrowed stock on the market for cash.

When the price of the stock falls, the short seller buys it back, returns it to the brokerage firm and profits from the drop in the share price.

A simple example

A short seller borrows 1,000 shares of Company A from a brokerage firm with the view that the share price will fall.

Then, he sells the borrowed shares on the market at, say, RM1 per share and raises RM1,000.

When the share price of Company A falls to 80 sen per share, the short seller buys the 1,000 shares back from the market with RM800.

He then returns 1,000 shares to the brokerage firm and pockets a profit of RM200.

Short selling in Malaysia

Today, Malaysian investors are able to short sell a list of approved stocks under the Regulated Short Selling (RSS) guidelines. As at July 28 last year, 270 stocks out of 806 qualified to be short sold, according to Bursa Malaysia.

The list is updated every six months.

To execute a short-selling order, an investor has to open an RSS trading account with a participating organisation (PO), which could be an approved investment bank or securities firm under Bursa. This allows the investor to borrow shares via the PO from the Central Lending Agency.

The Central Lending Agency is managed by Bursa Malaysia Securities Clearing, which is in charge of all local securities borrowing and lending activities.

The investor also has to pay a fee and put in sufficient collateral to borrow stocks via a PO.

Once the shares are successfully borrowed, the investor places short-selling orders with the PO and they are executed by a PO dealer.

However, investors should note that the short-selling order price must be higher than the last traded price of the stock he or she intends to short sell. This is due to the “uptick rule”, which is in place to prevent certain market players from strategically driving share prices down and creating a panic in the market.