Short selling

Short selling is the practice of selling borrowed stock with the expectation of earning a profit later, when the shares are bought back at a lower price. This is a risky position to take, since an increase in the stock price can create potentially unlimited losses for a short seller.

What can a company do about short sellers?  The CEO may be tempted to force them out by issuing guidance for better-than-expected earnings results.  This kind of publicity may initially increase the stock price, which (as just noted) creates an untenable situation for short sellers. In the short term, such guidance may quite possibly drive them away.

The problem is that the more aggressive guidance will make it very hard to meet investor expectations. If the CEO keeps issuing higher and higher guidance numbers, all the short sellers have to do is wait quietly until the stock price is clearly much too high, and then sell short in even greater quantities and turn a massive profit when the stock price inevitably craters. In short, the CEO’s own actions have manufactured profits for short sellers.

So obviously, increasing guidance is a bad idea.  There are several other actions to consider that are more workable. They are:

  • Never issue aggressive guidance.  Increasing the expected results of the business only raises the stock price to an unsustainable level.  Instead, issue conservative guidance which the company can comfortably meet on a long-term basis.  This approach reduces stock price volatility; with minimal stock volatility, short sellers will see little point in targeting the company.
  • Issue press releases. Monitor the larger investor message boards to see if there are sudden increases in negative discussions about the company.  Those increases may coincide with short selling. If there appears to be a smear campaign going on, then consider issuing a press release that addresses the substance of the allegations.
  • Rumors web page. Consider creating a web page on the company website, on which the company responds to any rumors being spread about it. This page will probably not be accessed a great deal, and so is unlikely to have much of an impact on the actions of the investment community.
  • Issue all bad news at once. Issue every scrap of bad news to the investing public at one time.  For example, if you report a bad quarter, short sellers may start monitoring the company, and possibly selling short, because they expect that the business will issue a string of more bad news that will drive the stock price down even further. Thus, when you know there is bad news, dump all of it on the market at once, so there will be no additional bad news for short sellers to feed on. The result should be a one-time drop in the stock price – and no further.
  • Shift company stock out of margin accounts. Company insiders may keep their stock in margin accounts. If so, they have probably signed a hypothecation agreement with their broker, under which the broker can extend a margin loan in exchange for lending out any security in the account as collateral to raise the capital needed to fund the loan. This means that shares in the company held by company insiders may be used for a short seller attack on the company. To avoid this situation, have all insiders move their company shares to a cash account with their brokerages.

In short, the overriding goal in dealing with short sellers is to temper your response. Never increase earnings guidance or alter company operations in order to drive away short sellers.  Instead, keep guidance conservative, and react to rumors with well thought-out press releases.