Now for something a little…different…this is my overlong response to an interesting post on short selling over at SramanaMitra.com.  Here’s the link to the original article:  http://www.sramanamitra.com/2009/04/04/capitalism-20-value-creation-vs-value-destruction/#idc-cover

Hi Sramana – Short selling puzzled me for a long time, not least of which because it did seem wrong that people could make money during downturns.  The underlying mechanism of a short sale is the borrowing of the security from an institution that’s currently holding that security as a long-term investment. Short selling would be ‘magical’ if not for this underlying transaction. What always confused me is why institutional holders allow this form of borrowing or even want to lend out the securities they’re holding ‘long’. It actually adds a ton of value, and hopefully I can explain that here.

Two main points:

1) Retail trading accounts that allow for shorting of securities are actually leveraging themselves in order to execute the short trade, which is why many brokers make sure that an account holder is qualified to trade on margin (leverage) before they’re allowed to short. The account holder is borrowing an asset from another entity, and therefore needs to be screened more rigorously than someone simply buying a security.

2) Since the asset is a borrowed asset, it needs to be returned no matter what happens to the stock’s price. This is why the entire mechanism is called a ‘short’ because you can only do it for a short period of time, as opposed to a ‘long’ position, which can be held a long period of time – like Warren Buffet, who likes to hold ‘forever’.

So what happens after this short period of time?

Essentially, whichever entity was so gracious to lend the securities in the first place to the short seller will, according to predetermined rules, initiate a ‘margin call’ – usually when they’re worried that the short seller won’t be able to cover the losses by a sudden price gain. A margin call for a short position won’t ever need to happen though if the borrower (ie – short seller) is able to close out the transaction, either at a reasonable loss or any level of profit.

Short sellers absorb a considerably higher risk by taking their position than long buyers do, because a stock’s price can always go many times higher than it’s currently priced. And this is the part where people usually say that it’s just gambling…because they think that since there’s a lot of exposure to loss above and beyond one’s investment, that it somehow means there is no value-added in the transaction. In other words, it’s not clear that the risk is even worth taking to the casual observer.  This couldn’t be further from the truth.  Short sellers are providing an enormous public service principally because their position on an asset class is so publicly available to anyone – through data sites like ShortSqueeze.com.  If an asset shows up here as having a high short-interest, I’ll be thinking twice before adding it to my long-term buy & hold list.

So where’s the value in that?

Let’s say you’re an institutional money manager who is holding billions of dollars in assets and your legal obligation is to invest it very conservatively. You’re not trying to do anything spectacular like double the money, just deliver for pensioners or fund holders a rate of return that beats both the risk-free rate of return and hopefully some of the major indices by a few percentage points. What is not tolerated in the least is any considerable loss of capital, or volatility in the returns achieved. In this environment, you don’t do anything crazy – no daytrading, no HFT, no shorting, and certainly no margin. Your institution will want to be holding large positions in major companies that are major, stable public companies generating dividends for shareholders or moderate and continuous growth – such as a utility company or a big tech company.

As a major institutional holder of these assets, you’re looking at multi-year strategies and rebalancing your asset holdings on a far longer timescale – this is a good thing, and it’s required to deliver consistent returns that beat the market. You also have a number of costs from acting as a holding company of this kind, and despite being unable to generate high-flying returns from high-frequency trading or trading on margin, you still have plenty of staff and need to meet payroll. So how can you generate a little extra income on the side?

The answer is to become a securities lender. (see the Wikipedia link below)

In this way, you can still say that you are a long-term holder of, say, Microsoft stock because you own the stock and will not yourself, as a money management firm, sell that stock for years. You may in fact only be allowed to buy the stock up on price down-turns given your legal mandates. But lending out stock to people who are willing to play in the short-term space becomes an excellent way to make extra money. Folks who short stocks believe they are spotting something that will cause indisputable downturn in a share’s price.  The institutional guys may see the exact same opportunity…but legally they can do absolutely nothing about it because they cannot legally sell any of their shares – that would be daytrading and have negative consequences.  All an institutional guy can do is sit and hope that their long-term stake doesn’t really go off a cliff, but they cannot sell on impulse if they’ve already made strategic commitments like the one’s I’ve outlined above.

So if they instead lend out shares to people who want them for testing out their bearish theories, they get to bridge the gap and make money by virtue of their big stash of securities holdings which cannot be sold.

So that’s the value-add for institutional money managers who are under restrictions. What is they end-game value for society or the world at large by all this activity?

Again, the short seller can be right or wrong about the potential price movement, and when they are right they add value to society and enrich themselves in a fair trade. When a short seller is correct that a security’s price will erode, they are essentially making a public statement that the other shareholders must pay attention to:  either “you are all being irrationally exuberant” or “you are not seeing nearly enough danger” – an analyst saying the same thing can never carry the same weight as a short seller, because a short seller’s is actually taking a risk on the outcome of their forecast while an analyst is paid a salary to do research ad nauseam and will experience no significant pain when their research fails to add value.  When a stock is being heavily shorted, it is a very public and useful warning sign to conservative investors that the stock has been scrutinized and may be headed for a fall.

That’s why having the shorting information on a stock is powerful for any sort of investor, and why we should never allow governments to ban the practice outright. Short sellers who are wrong pay dearly for their miscalculation as they can get margin called into oblivion during the infamous ‘short squeeze’ effect.  They do not need to be criminalized for putting their money behind their predictions and absorbing inordinate risk to do so.

Lastly, since price manipulation was mentioned in this debate, let me just say that price manipulation and short selling are two different things.  I’m all for outlawing price manipulation or insider trading schemes, and the SEC’s job is both a difficult and worthwhile one.  Banning short sales on the other hand will only serve to injure the markets, injure investors, and injure employees at any public company that is itching to avoid the heightened scrutiny and hype-busting skepticism that the short selling market generates for public consumption.  There is a very good chance that market crashes would be decidedly harder and more destructive without short sellers spotting their potential in advance, alerting the public via the size of their positions, and then buying back the underlying asset when they take profits.  Unlike the vast majority of investors who have to be pessimistic and sell when they take profits, short sellers are the only optimistic people in the room when taking profits, putting in a bottom and shouting, “This is just getting ridiculous now…the world is surely not coming to an end”  Those buybacks, just like any other buybacks, cause the share price to increase.  Usually the first leg up out of the abyss of a market crash is caused by short sellers covering their shorts, taking profits, and buying back the assets.  In this way, they are actually the leaders or early adopters of almost every stock market recovery.

Here are some references:

http://en.wikipedia.org/wiki/Securities_lending

http://shortsqueeze.com/

http://en.wikipedia.org/wiki/Short_squeeze

http://answers.yahoo.com/question/index?qid=20070815161225AArHZy5