Short Sellers (#74)
/In this podcast episode, we discuss how short sellers do business and how to deal with them. Key points made are noted below.
What is a Short Seller?
A short seller is someone who expects a company’s stock price to decline in the near term; so he sells borrowed stock with the expectation of earning a profit later, by buying backing the stock later on at a lower price.
Conflicts with Short Sellers
The CFO’s job is to increase the stock price, while the short seller’s job is to force it down, so you’d expect accounting people to treat short sellers like the arch enemy. We’ll talk about how short sellers work, and how best to deal with them.
The Short Selling Process
The basic short selling process involves three steps. First, the short seller borrows the target company’s stock, usually from a broker. Next, he sells the shares on the open market. And third, the short seller waits for the stock price to decline, then buys back the shares, and returns them to the lending broker. So if the stock price declines, the short seller makes money, and if the price increases, then he loses money.
Short Selling Risk
Short selling is a very risky activity. For example, if a company’s stock sells for $10 and its price drops all the way to zero, then a short seller can earn a maximum of $10. However, if the price increases to $40, then the short seller has just lost $30 – so there’s an unlimited potential for losing money. Given the risk, it’s no surprise that some short sellers will try just about anything to ensure a stock price decline, like planting false rumors on electronic bulletin boards. They can do this with multiple aliases, so it seems to someone who’s casually visiting the site that there’re a lot of people who are selling their shares.
One of their favorite tricks is to monitor restricted stock holdings, and figure out when the restrictions are coming off the shares under the SEC’s Rule 144. Since the timing of restriction cancellations are public knowledge, short sellers can anticipate when investors might start dumping large amounts of stock on the market, which drives down prices. Then they sell shares in advance of the big sell-off, and buy shares back when prices are very likely to be lower.
Dealing with Short Sellers
So, what can a CFO do about this? Some CFOs may be tempted to force out short sellers by issuing guidance for better than expected earnings results. This kind of publicity may increase the stock price in the very short term, which creates a squeeze that does drive away the short sellers.
The problem is that the more aggressive guidance will make it really hard to meet investor expectations. And that means that the short sellers will return in droves, because now the stock price is even higher, and so has a longer way to fall. If a CFO keeps issuing higher and higher guidance numbers, all the short sellers have to do is wait quietly until the stock price is clearly way too high, and then sell short in even greater quantities, and turn a really big profit.
So obviously, increasing guidance is a bad idea. So what can you do? First option: don’t ever issue aggressive guidance. All that does is raise the stock price to an unsustainable level. Instead, only issue conservative guidance which the company can comfortably meet on a long-term basis. This approach flattens stock price volatility, which keeps the short sellers away.
It also pays to monitor the larger investor message boards to see if there’re sudden increases in negative discussions about the company. Those increases usually coincide with short selling, which you can also monitor on a web site called shortsqueeze.com. If there appears to be a smear campaign going on, then consider issuing a press release that addresses the allegations.
Another tactic is to issue every scrap of bad news to the investing public at the same time. For example, if you have a bad quarter and report it as such, this will at least get short sellers to start monitoring the company, and possibly selling short, because they expect that you’ll issue a string of additional bad news that will drive the stock price down even further. So… when you know there’s bad news, dump all of it on the market at once, so there’s a single stock price decline, and that’s it. No more additional declines for the short sellers to feed on.
It also pays to be prepared for every reasonably foreseeable emergency. The CFO can create boilerplate press releases for such issues as product recalls, litigation, or the departure of a key executive. By having these canned responses available, it gives the appearance that the company responds both quickly and well to a crisis. If management appears competent, there tends to be less stock volatility, and that keeps the short sellers away.
Short sellers may also get into an investor conference call and pose questions that make the company look bad. Their intent is to plant the idea in other investors that management doesn’t know what it’s doing, which can drop the stock price. If this happens, the worst things you can do are to get into an argument, or to give a long-winded and rambling answer. Instead, make a short and well-reasoned reply, and immediately move on to the next caller. Do not let a short seller hog time during the conference call.
There’s a short selling ratio that you might want to consider using. Divide the number of shares being sold short by the average daily volume of shares traded. This gives you the short interest ratio. When tracked on a trend line, it reveals when there’s a short selling attack going on. Also of interest, it shows the number of days of average trading that it takes before short sellers can cover their positions. As the ratio goes up, this means that it becomes increasingly difficult for short sellers to cover their positions, so they’ll have to scale back on their short positions.
In summary, you should absolutely never increase your earnings guidance in order to drive away short sellers. Instead, keep guidance conservative, and try to react to rumors with well thought-out press releases. If you do this, there’ll still be some short selling, but there won’t be enough negative information for short sellers to cause major problems.