By LARRY SWEDROE
Short sellers play a valuable role in keeping market prices efficient. Market efficiency is important because an efficient market allocates capital efficiently. If short sellers were inhibited from expressing their views on valuations, securities prices could become overvalued and excess capital would then be allocated to those firms.
The importance of the role played by short sellers has received increasing academic attention in recent years. Research into the information contained in short-selling activity, including the 2016 study The Shorting Premium and Asset Pricing Anomalies, the 2017 study Smart Equity Lending, Stock Loan Fees, and Private Information, the 2020 study Securities Lending and Trading by Active and Passive Funds and the 2020 study The Loan Fee Anomaly: A Short Seller’s Best Ideas, has found that short sellers are informed investors who are skilled at processing information, as evidenced by the findings that stocks with high shorting fees earn abnormally low returns even after accounting for the shorting fees earned from securities lending. Thus, loan fees provide information in the cross-section of equity returns. Interestingly, while retail investors are considered naive traders, the authors of the 2020 study Smart Retail Traders, Short Sellers, and Stock Returns found that retail short sellers were informed traders who profitably exploit public information when it is negative.
Alexandre Madelaine, Luc Paugam, Hervé Stolowy and Wuyang Zhao contribute to the literature with their December 2021 study, Pessimistic Target Prices by Short Sellers, in which they investigated the pessimistic target prices provided by short sellers. Their dataset is from Activist Insight Shorts and covered 1,487 short-selling attacks issued by activist short sellers from 2010 to 2018. Among those attacks with return information available, 637 explicitly included target prices for the attacked stocks. Following is a summary of their findings:
- From 2010 to 2018, the proportion of short-selling attacks including target prices more than doubled, from 28 percent to 65 percent.
- In 637 attacks with target prices, short sellers claimed that the attacked firms’ stock prices should drop by 65 percent on average (range was from 6 percent to 100 percent), but the mean (median) decline was just 7 percent (16 percent) one year after the attacks.
- The return decreased for six months and reached its minimum half a year after the attack, at -10 percent. After a year and two years, the mean returns were less negative, at -9 percent and -2 percent, respectively. However, median returns became more negative over time: -11 percent after six months, -18 percent after one year and -22 percent after two years.
- Considering only the lowest price in the year following the short-selling attacks, the mean drop was 40 percent, and only 17 percent of attacks reached their target prices.
- The immediate market reaction was stronger in response to analyst reports that included target prices: In the two-day window starting from the report announcement date, reports with target prices led to a mean price drop of 6.2 percent, whereas reports without target prices led to a mean price drop of 4.7 percent. However, the return difference between attacks with and without target prices disappeared within the first week following the attacks.
- Among short-selling reports with target prices, the actual returns were monotonically more negative as the short sellers predicted larger price declines — for stocks targeted by the 39 reports arguing for a less-than-30 percent downside, the stock prices dropped by only 0.8 percent on average after one month versus drops of 16.5 percent on average for stocks attacked by those 88 reports arguing for a 100 percent downside.
- For reports including a target price, there were more frequent corporate responses (+4.8 percentage points), more generous cash distributions (+5.6 percentage points), CEO resignations (+3.8 percentage points) and shareholders’ class actions against the shorted company (+5.7 percentage points)—target prices are relevant to managers and shareholders.
Their findings led Madelaine, Paugam, Stolowy and Zhao to conclude: “Consistent with prior research, we find that short sellers are able to identify overvalued stocks, but we also provide new evidence that short sellers are largely incorrect in the level of their valuation due to excessive pessimism.” They added that despite the excessive pessimism, the target prices are relevant for market participants because the disclosure of target prices accelerates price adjustment, the implied return of target prices predicts subsequent returns, and the disclosure and the implied return of target prices are associated with various responses from the attacked firms and shareholders. They did add the caution that “short sellers can be both informative and severely biased at the same time.”
Madelaine, Paugam, Stolowy and Zhao also cited evidence demonstrating that the buy recommendations of sell-side analysts exhibit a positive bias — their price targets are overly optimistic. Thus, it should not be a surprise to learn that short sellers, with very different incentives, would exhibit a pessimistic bias. However, they did find that the short sellers’ negative bias is much larger in absolute terms than the positive bias exhibited by analysts.
The researchers also added this caveat: “The inaccurate target prices do not mean that short sellers are intentionally exaggerating the overvaluation. For example, this can be also because (1) short sellers tend to short stocks they feel particularly pessimistic about, or (2) there is noise in measuring bias as the true fundamental value of shorted stocks is unobservable. The authors leave it for future research to explore the sources of this pessimistic bias.”
There is a large body of evidence demonstrating that short sellers are informed investors who play a valuable role in keeping market prices efficient; in other words, short sellers’ target prices lead to faster price discovery. However, short sellers who publish target prices are overly pessimistic.
The research on short selling has led some “passive” (systematic) money management firms (such as AQR, Avantis, Bridgeway and Dimensional) to suspend purchases of small stocks that are “on special” (securities lending fees are very high). Dimensional has done extensive research on securities lending. Using securities lending data for 14 developed and emerging markets from 2011 to 2018, it found that stocks with high borrowing fees tend to underperform their peers over the short term. Moreover, stocks that remain expensive to borrow continue to underperform, but persistence of high borrowing fees is not systematically predictable. While the information in borrowing fees is fast decaying, it can still be efficiently incorporated into real-world equity portfolios.
Dimensional also found that while high borrowing fees are related to lower subsequent performance, it is not clear this information can be used to make a profit by selling short stocks with high fees. Borrowing fees are just one cost associated with shorting; short sellers must also post collateral, typically at least 100 percent of the value of borrowing securities, and incur transaction costs. In addition, its research shows there is relatively high turnover in the group of stocks that are on loan with high borrowing fees. For example, fewer than half of high-fee stocks are still high-fee one year after being identified as such. Therefore, excluding these stocks may lead to high costs if buy and sell decisions are triggered by stocks frequently crossing the high-fee threshold. After considering the tradeoffs between expected return, revenue from lending activities, diversification, turnover and trading costs, Dimensional believes that an efficient approach to incorporate these findings into a real-world investment process is to consistently exclude from additional purchase small-cap stocks with high borrowing fees.
Avantis takes a different approach in designing its fund construction rules. It tries to avoid holding securities that tend to have characteristics associated with high lending revenues and shorting. AQR also uses the information in some of its portfolios — a high shorting fee is used as a signal to sell short the hard-to-borrow names, assuming AQR forecasts a positive expected return (net of the fee). It does so based on the academic evidence showing that high short-fee names are predictive of lower returns even net of their higher fee.
Finally, investors may benefit from the research findings without shorting stocks. They can do so by avoiding purchasing high-sentiment stocks where borrowing fees are “on special”.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party information and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-208
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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