Short sellers: ‘unreasonably maligned’ or ‘jerks’?

Tesla chief executive Elon Musk doesn't like his critics. He has taken on analysts asking "boring, bonehead questions", Reuters journalists ("relentlessly negative"), a public transport expert ("sanctimonious idiot"), and a British cave diver ("pedo guy"). However, there's one constituency of people for whom Musk reserves a special level of opprobrium – short sellers. Short sellers make money when a stock they have bet against declines. For a long time, they've been betting against the electric car maker. More than a quarter of Tesla's stock has been shorted.

That’s an extreme reading; data provider IHS Markit recently noted there has never been another US equity short position mirroring Tesla’s that has lasted for so long.

In 2012, Musk defended the shorts, saying they were “often unreasonably maligned”, but he has changed his tune since then. The insults keep coming – shorts are “jerks who want us to die”; they “want us to die so bad they can taste it”; they are “constantly trying to make up false rumours”; they are a source of “extreme torture . . . desperately pushing a narrative that will possibly result in Tesla’s destruction”.

Such hyperbole tends not to go down well with Tesla’s investors, who would largely prefer if Musk kept a lower profile. But he finds it difficult to hide his distaste. Earlier this month, just days after Tesla investors breathed a sigh of relief following the company’s settlement with the US Securities and Exchange Commission (SEC) over charges of misleading investors, Musk stirred the pot once again, calling the SEC the “Shortseller Enrichment Commission” and claiming that short selling “should be illegal”.

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History of suspicion

Musk’s language can be colourful, to say the least, but he’s just the latest in a long line of figures to view short selling with suspicion. The practice was banned by Dutch regulators in the 17th century and by their British counterparts in the 18th century. A century later, Napoleon put the boot in, decrying the short seller as an “enemy of the state”.

Unpatriotic, said US president Herbert Hoover in the years following the 1929 Wall Street crash, asking the Senate to investigate “sinister . . . bear raids”. During the global financial crisis in 2008, policymakers, bankers and even bishops complained about the practice, with partial bans being temporarily introduced in a number of countries (including Ireland). Last year, president of the New York Stock Exchange Tom Farley called for more transparency, saying betting against a company “feels kind of icky and un-American”. It may feel “icky”, but short sellers perform many valuable roles in financial markets. Just as value investors seek undervalued companies, shorts say they are contrarians who sniff out overvalued stocks and bet accordingly.

Fund managers and analysts, eager to maintain harmonious relations with company management and key figures in the investment world, often have little incentive to rock the boat. In late 2015, for example, most investment analysts covering UK construction giant Carillion had buy ratings on the stock.

The obvious clue suggesting that all was not well with the company, which collapsed in January 2018, was the fact it was already the most-shorted stock on the London market.

It was a short seller, Andrew Left of Citron Research, who helped expose the questionable practices at pharmaceutical giant Valeant, which saw its share price collapse by more than 90 per cent following accusations of drug price gouging and accounting fraud.

Elon Musk may not be keen on hedge fund managers Jim Chanos and David Einhorn, both of whom have shorted Tesla stock, but both men can point to valuable detective work they have carried out in the past (Chanos famously exposed the house of cards that was Enron in 2001, while Einhorn was warning about dubious accounting practices at Lehman Brothers in 2007).

Multiple studies confirm these are not isolated examples. For example, a 2010 study, Short Sellers and Financial Misconduct, found shorts "ferret out and help uncover financial misconduct", betting against dodgy companies long before public confirmations of fraud. The more a company cooks the books, the study found, the more likely there is to be an increase in short selling. Short sellers, it concluded, "play a significant role in identifying, uncovering and mitigating the effects of financial misconduct".

Investor benefits

Shorts benefit investors in many other ways. By betting against high-flying stocks where share prices have become divorced from the fundamentals, they help curb animal spirits. Although critics complain that shorts magnify declines by piling on in times of trouble, the opposite is often the case. When a stock falls heavily, shorts can bank their profits by closing their position and buying back stock, helping prevent a cascade in prices.

Shorts make markets more liquid; research shows bid/ask spreads tend to widen when regulators place restrictions on short-selling. Importantly, shorting also helps lower investment costs for ordinary investors. To bet against a company, shorts must first borrow the stock from long shareholders. Fund managers charge a fee for these loans, helping them to reduce management fees charged to investors (in the US, fund giant Fidelity recently responded to increased competition from low-cost rivals by launching two free index funds). Chief executives are sometimes slow to recognise these benefits, but financial markets tend not to be impressed by those who loudly decry short sellers.

Tesla’s share price, for example, quickly sank by more than 7 per cent after Elon Musk called for the practice to be banned, earning a one-day profit of $645 million for short sellers, according to data from financial analytics firm S3 Partners.

"His whole focus on shorts is a misallocation of his time and resources," says Quoth the Raven Research founder Christopher Irons, who is short Tesla stock. "Short sellers will go away if he executes on his business plan and will grow in numbers if he doesn't."

The Netflix approach

Chief executives might be better served by following the example of Netflix chief executive Reed Hastings, who responded in an altogether different way after short seller Whitney Tilson revealed his bearish outlook on the company in 2010.

Shorts “are a positive force in capitalism”, said the Netflix man, who acknowledged that chief executives “are generally biased in their bullishness on their respective firms”. There were “many risks ahead for Netflix”, he admitted, adding that Netflix’s valuation was “substantial”.

Whitney Tilson is a “great investor and a wonderful human being”, said Hastings, but he nevertheless felt the short thesis was wrong, explaining why on a point-by-point basis. “Short or long, I look forward to dinner and drinks together in the New Year,” Hastings’s letter concluded. “Respectfully, your ally and admirer.”

Soon after, the two men met. The meeting “caused us to question a number of our assumptions”, said Tilson, who closed his short position and lauded Hastings as “one of the most down-to-earth, honest and straightforward CEOs we’ve ever encountered”. Might Elon Musk follow suit? Will he stop mocking David Einhorn, to whom he posted pairs of boxer shorts “to comfort him through this difficult time” after the hedge fund manager reflected on recent heavy investment losses? Will he kiss and make up with Jim Chanos, who has said Tesla is “worth zero”? No, probably not.