Short sellers should be engaged with rather than reviled
The recent furore around activist short selling, particularly surrounding research firm Viceroy, has brought some interesting attention to both the role of research houses and the contextual implications of their work.
Broadly, short sellers are investors who take investment positions on companies whose share price they believe will decline due to weak fundamentals or operating irregularities — often these investors glean these insights from internally generated research. Activist short sellers bring a more targeted approach to short selling — often involving bringing new information to the market that is deemed to be material to the value of the company.
Such information would relate to management impropriety like fraud, misstating of earnings or earnings risks and outlook, among many other issues. Simply, they are like the classroom monitors who report on the misbehaviour of pupils the teacher might not see. If this is so, why are these activist short sellers received with so much scepticism and disdain in the investment community?
A growing number of dissenters on short sellers lament their role in manipulating company share prices downwards for their own material benefit. They often argue that short sellers can be predatory in nature without following sound research methodology to inform the insights they generate.
Intellidex, for example, published a report chastising Viceroy, titled Investment Research in the Era of Fake News, which was commissioned by Business Leadership South Africa.
In January Viceroy published a report stating: “Based on our research and due diligence, we believe that Capitec is a loan shark with massively understated defaults masquerading as a community microfinance provider.” The detailed Intellidex report ultimately argued that “the purpose of the release of such research reports rather seems to be to manipulate market prices instead of the self-expression of genuinely held beliefs”. It challenged the research methodology, the industry experience of the Viceroy team, their authenticity and their intentions in publishing the Capitec report.
Intellidex may have missed an opportunity to robustly engage with a changing market dynamic in the investment space — particularly the importance of activist short sellers. I draw some interesting parallels between activist short sellers (the ugly ducklings) and sellside research houses that hold a beneficial interest in the companies they release investment reports on.
1. Share price manipulation:
Narasimhan Jegadeesh, Joonghyuk Kim, Susan D. Krische and Charles Lee in their 2004 paper, Analysing the analysts: When do recommendations add value?, empirically find evidence that changes in the direction of analyst recommendations were strong predictors of future stock performance. This means that all research houses, whether activist short sellers or not, may materially influence the direction of a company’s share price based on their research recommendation. Michael B Mikhail, Beverly R Walther and Richard H Willis in their 2007 paper, When Security Analysts Talk, Who Listens?, corroborate the argument that fund managers seemed to place large importance on the information content of analyst recommendations.
2. Disciplining Earnings Manipulation:
Company management is held to account for the operating performance of the company in various ways. Analysts attend site visits and results presentations, and follow internal research processes to ultimately ensure that companies are thoroughly analysed and that investor monies are not at risk. The result of the presence of these analysts becomes a policing effect on company management and deters unscrupulous behaviour.
3. Proprietary Research Methodologies:
Most research houses will only disclose at a high level the research methodologies they use, primarily for competitive reasons. It appears an inordinate amount of attention is placed on the activist short sellers to be more transparent about their research approach and methodologies while their counterparts are not subjected to the same pressure.
There is sufficient literature that theoretically and empirically proves the importance of short sellers in disciplining earnings manipulation by companies, price discovery, increasing liquidity as well as market efficiency.
No one likes the bearer of bad news, particularly relating to a stock that was once a darling of the market. I once wrote a negative stock recommendation on PPC when it was trading above R30 per share. I argued that the company was going to face increasing competition and had earnings concentration risk, and operationally there were many fixes that needed to be put in place. I was criticised and accused of being sensationalist. The share now trades around the R7 mark, confirming what I held as a negative view for the earnings prospects for the firm.
Much of the negative attention on short sellers needs to take a more constructive tone. Such a tone involves a proper framing of the short-selling issues and adequate contextualisation of those issues.
Short sellers in South Africa are often the hedge fund managers, making up only a tiny component of total assets under management, in comparison to the more traditional investments in the sector.
Novare reported that the hedge fund industry had a mere R62-billion of assets under management in 2017, down from about R69-billion in 2016. The growth in activist short sellers signals a growing intolerance of abuse of investor funds, and instead of being chastised, this group ought to be robustly engaged with, particularly regarding the value they propose to bring for the financial sector.