It’s Not Easy Being a Stock Market Villain


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It’s not easy being a short-seller. The odds are stacked against you from the outset. Stocks tend to climb over time, so unlike peers who buy stocks before they sell, you don’t have the tailwind of a rising market. Then you have to navigate a tricky risk-management dynamic: When you’re right, your stocks go down but that diminishes position size and hence your potential return; when you’re wrong, your position grows, heightening your risk. As a short seller, the maximum you can make on a stock is 100%, yet potential losses are uncapped.

If that’s not enough, there’s a stigma to taking the other side in a world where most people cheer for rising prices. In his recently published memoir, John Mack, former chief executive officer of Morgan Stanley, is clear about who he sees as the villains of the global financial crisis: “These short sellers were destroying a storied franchise, built over almost three-quarters of a century of hard work and integrity.”

Research firm Hindenburg Research has found itself subject to similar derogation after publishing a barrage of criticism against India’s Adani Group and disclosing a short position in securities linked to the group. In response, Adani branded the firm “the Madoffs of Manhattan” and argued that the report amounted to “a calculated attack on India.”

Given the challenges, it’s no wonder high-profile short sellers have given up. In 2021, Bill Ackman announced his retirement from activist short-selling. That was after losing $1 billion on Herbalife Nutrition Ltd., which nevertheless went on to underperform the index. “The moral of the story: Short selling is not a good way to make money,” he wrote last week. “But it does make for good documentaries.”

Yet, the role short-sellers fulfill in maintaining efficient capital markets is an important one. They augment liquidity, since for every short seller there is a party on the other side of the transaction willing to pay the given price. And, importantly, they do help to detect fraud.

This last function is especially pertinent. In a recent paper, researchers from the universities of Toronto, California and Chicago estimate that “on average 11% of large publicly traded firms are committing securities fraud every year.” The authors reckon that in normal times only one-third of corporate frauds are detected; in aggregate, such deception destroys 1.7% of equity value per year, equivalent to $744 billion in 2020.

While regulators, auditors and research analysts have a responsibility to combat cheating, they often lack the right incentives. Auditors are directly paid by the companies they oversee; regulators lack the resources that are available in the private sector; and research analysts don’t necessarily see it as their job. “It is an analysts’ job to sell ideas,” one told a German parliamentary inquiry into the Wirecard AG scandal. “Wirecard was one of my strongest recommendations.”

With a profit incentive, short-sellers are uniquely placed. Unlike whistle-blowers, who can win a share of penalties the Securities and Exchange Commission imposes on proven fraud cases, short-sellers are outsiders and rely on public information. Armed with sufficient curiosity and tenacity, they can get paid well to dig where others don’t want to.

But it’s a labor-intensive activity. Given the weight of interests on the other side, the burden of proof is high. An anonymous report that spotlighted fraud at Chinese coffee chain Luckin Coffee Inc. in early 2020 involved more than 1,500 individuals counting customers in 4,000 of the company’s stores and recording more than 11,000 hours of video, according to the Wall Street Journal. Hindenburg’s 100-page report on Adani was the culmination of a two-year investigation

In its response, Adani said many of the points made by Hindenburg are “already in the public domain” – as they should be, given rules about insider information. Adani also highlights Hindenburg’s profit motive as a conflict of interest: “Hindenburg has not published this report for any altruistic reasons but purely out of selfish motives.” Of course, the incentive also exists to feed the market with misinformation, and given the stock’s slide since the report was released, Hindenburg has made money regardless. But if it is to be in business for the long haul, the firm is equally incentivized to protect its reputation.

Aligning incentives is difficult, but the role activist short-sellers play in keeping markets fair has wide benefits that shouldn’t be discounted. There will always be cheerleaders for rising prices creating a market for over-optimistic projections and fake numbers. It’s important to have a counterweight,…



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