Short sellers play important role in separating wheat from chaff
These investors can help identify firms with unsustainable or irregular business practices
Embrace short sellers” is my message to those who are up in arms over Viceroy’s report and short position in Capitec, and here’s why. The sole purpose of markets is to allocate capital between those parties with excess cash (investors) and those companies needing cash. It is neither in the interests of investors nor society as a whole to have capital allocated to firms that have questionable or unsustainable business practices, or have accounting irregularities and/or are scams or frauds. Short sellers help sniff out these companies.
Furthermore, I would argue that short sellers are even more important these days because, given the rise in popularity of passive funds, the longer potentially unsustainable operations are left unchallenged the more of society’s money becomes passively invested in the firm.
From 1999 to 2001 I researched short positions for a South African-based hedge fund. We did work similar to Viceroy’s when researching our short positions, which included African Bank and Profurn. We scrutinised the reports and accounting policies and secured pay slips of employees showing zero take-home pay. We presented our conclusions to financial institutions.
Some agreed with us, some didn’t, we got some shorts right, we got some wrong — that’s the nature of the market. But part of me regrets that we didn’t take a more active stance and notify regulators of the goings-on in the industry back then. African Bank had only R4bn of loans and R3bn of liabilities, far less than the R50bn of net loans and R58bn of total liabilities last reported in 2013.
In my opinion, short sellers are the analyst equivalent of investigative journalism and society needs investigative journalists. If those brave sleuths hadn’t exposed the Guptas’ e-mails, perhaps state capture would still be around today.
Short sellers are no different. They go in search of “the truth” and it is surely in the interests of regulators, investors and society to know the truth.
However, they don’t always find “the truth” and sometimes invent ghosts, expensive ones. Bill Ackman famously thought he had identified Herbalife as a “pyramid scheme” in 2012. He bet $1bn that Herbalife would go to $0. The shares sold off, but this provided an opportunity for a savvy investor like Carl Icahn to begin building his 26% stake.
Herbalife has since risen 250% and in 2017 Pershing bought back their short position, with Ackman losing credibility and his clients losing billions.
For unlike long-only investors who buy shares and are exposed to the potential upside of a share price soaring, unless short sellers use fancy derivatives they can only make 100%. And that’s only if the business goes bankrupt.
PUMP AND DUMP
This skewed risk-return tradeoff, where you can make 100% but lose multiples of your capital, is why sophisticated short sellers don’t normally partake in the short equivalent of a “pump and dump”.
Why do all that investigative work to only make 10% on the news of your report?
No, I think sophisticated short sellers rather go for the jugular or the “home run”, because only then is the riskreward trade-off worthwhile.
We may rely on analysts and fund managers to know every last detail about companies, but in a study conducted in 2003-12 on data requests from the US corporate filings depositary, the average US publicly traded firm had its annual report requested only 28.4 times immediately after filing, a low statistic for the annual report, a vital piece of company research.
But then how many Naspers holders have read Tencent’s annual report in great detail and are aware that Tencent is not a Chinese technology company but a Cayman Islands company listed in Hong Kong, with some “structure contracts” with Chinese technology companies that are owned by Tencent’s CEO and founders, which they disclose may or may not even be valid in accordance with Chinese laws and regulations?
Viceroy’s tactic of calling for Capitec to be placed into curatorship seems extreme to me, but we should all be free to express our opinions. Are they any more guilty of market abuse than the Twitter feeds and financial news websites providing a link to their research?
Viceroy’s report has a lengthy disclaimer that says: “Think critically about our opinions and do your own research and analysis before making any investment decisions. We are not registered as an investment adviser in any jurisdiction.”
Should everyone issuing an opinion on any listed company — newspaper columnists, radio and TV interviewees and Twitter commentators — be regulated? Surely not. Viceroy didn’t force anyone to sell their holdings; people sold because they feared their research was right.
But it is also important to recognise that those with conviction that Viceroy’s research was wrong have been given an opportunity to buy at a lower price. Ironically, the market perhaps now better understands Capitec’s business model after its management went to great lengths to dispute and explain the errors they see in Viceroy’s thinking. If the aim is finding “the truth”, surely this public debate is what we all want? I think Resilient and Naspers would do well to follow suit and tackle the concerns raised in the reports of 360ne and Investec.
I see no difference between fund managers writing about companies they hold in their funds and short sellers doing the opposite. With one caveat. If short sellers “short and distort — that is, spread false rumours and then close positions when the share temporarily falls — that would be market abuse.
So rather than shoot the messenger, I suggest investors be open-minded about the work short sellers do. They take a lot of financial and personal risk. They go against all the vested interests and play their part in helping society allocate capital efficiently. They are not always right and if they are wrong they pay a heavy price.
VICEROY DIDN’T FORCE ANYONE TO SELL; PEOPLE SOLD BECAUSE THEY FEARED THEY WERE RIGHT