Activist Short Selling

I analyzed the performance of the most famous activist short sellers over the past 5 years. Here are the results!

Jun 26, 2022

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Activist Short Selling is one of the most controversial topics in the stock market. I believe it’s neither well understood nor commonly used by retail investors. There are arguments from both sides with some stating that short-sellers manipulate the market with their reports and should be reigned in by the S.E.C whereas others argue that short-sellers are watchdogs that police the financial markets!

While I have no expertise to comment on the legalities of short selling, what I can do is see if we can make money out of their recommendations! I have collected the recommendations/reports made by some of the biggest activist short-selling firms over the past 5 years. This would be the ultimate litmus test for short-sellers as barring 2022, it has predominantly been a bull run and 2020-2021 was the period when the everything rally was going on!

But before we jump into the results, it’s important to understand how short-selling works and how companies and investors make money out of it.

What is Short-Selling?

Typically, most of us make money in the stock market in the form of capital gains and dividends. When we are bullish on a stock, we buy it in the hope that the stock price appreciates over the holding period.

But what if you are bearish about a stock? Maybe you don’t like Facebook due to their lax privacy concerns or you think Tesla is overvalued for the number of cars they sell - What can you do in such a situation to make money?

The answer is short selling. It’s the process of borrowing a security and then selling it in the market. You then purchase it later at a lower price thereby pocketing the difference as profit. An example would make this much clearer.

Let’s say Apple stock is trading at $100 per share and you expect its price to go down. You borrow 100 shares and then sell them for $10K (At its current market value). 2 days later, they release an abysmal earnings report and the stock price crashes to $80. Now you purchase 100 shares at $80 for $8K and then replace the shares you borrowed thereby netting a cool $2k from the crash1.

The astute among you might have noticed a critical risk with this strategy → that your gains are limited but your losses are unlimited. The max profit that you can make in this trade is $10K (if the stock goes to zero aka bankruptcy) but the max loss can be unlimited. If the stock jumps to $200, you are down $10k (100% loss) and if the stock jumps to say $500, you are down $40k (300% loss). This is exactly how hedge funds shorting GameStop stock went bankrupt during the meme stock rallies.

Now that we have an insight into how we can make money betting against stocks, let’s look at some of the most popular activist short-sellers whose calls I have analyzed.

The Contenders

While there are hundreds of companies and hedge funds that short stocks to make a profit, I am focusing only on the ones that make their reports public. If these companies do end up making a killing in the market, only public reports allow us to follow their recommendations. I have analyzed 4 activist short-sellers for this research.

Hindenburg Research (33 reports in the last 6 years): The most famous activist short seller on the market. These guys are the ones that released the reports on Nikola (Which caused the stock to drop by 40% and the SEC to open an inquiry into Nikola) and Clover Health.
J Capital Research (26 reports in the last 5 years): Although they focus mainly on Chinese markets, they have issued short reports for multiple companies listed in the US as well. For all the controversies associated with short sellers, they were also one of the most transparent companies I came across - Below is the header taken directly from their homepage2.
Be warned. We are activists, usually on the short side. We are biased. We do our best to find and present facts, based on extensive primary research and using public sources. But we will profit if these stocks decline or, when we are long, rise in value.
Muddy Waters Research (12 reports in last 5 years): They produce reports on business, accounting, and fundamental frauds in companies. They also mainly focus on the Chinese market. The firm is best known for spotting fraud at Sino-Forest Corp, a Canadian-listed Chinese company whose stock fell 74 percent before it eventually filed for bankruptcy.
The Bear Cave (31 reports in the last 2 years): This one is the most interesting one among the bunch. Bear Cave is exposing bad companies twice a month. What distinguishes Bear Cave from all the others (Other than its accessibility to retail investors) is that Edwin Dorsey, who issues these reports, does not take positions against the companies and instead makes money solely from paid subscriptions. I guess this allows him to be more objective in his reports.

Results

Would you look at that! Short-seller reports absolutely wreck the stock performance. In all the cases, the 1-year performance preceding the short report was stellar but after the reports, the companies significantly underperformed the benchmark.

Let’s take a look at the performance of The Bear Cave. Edwin made 31 short reports over the past 3 years. On average, these stocks returned a whopping 297% in just one year preceding the report. But, after the reports were issued, the average return for the next year was only -0.5%. Also, these stocks fell 8.2% on average just one day after the short report was issued.

Also, from our research, we can see that short sellers are not there for short-term stock price manipulation. The average performance of these stocks after one month, one year, and to date3 are all negative and considerably lower than S&P 500! This shows that in most of these reports, the short sellers showcase fundamental issues related to the businesses they are issuing the reports on.

Finally, let’s see some of the best calls made by short-seller firms. Hindenberg Research is famous for bringing down some really big companies such as Clover Health and Nikola. Their short report on Nikola was directly responsible for Trevor Milton resigning from his Executive Chairman position. They also issued a short report on Lordstown Motors which alleged that the company’s 10,000 pre-orders were largely fictitious and used as a prop to raise capital.

Limitations

The results do look rosy for the short sellers but you should be aware of some of the limitations in the research

Companies that were listed outside the US and covered by the short sellers were not considered in this analysis. The overall performance can be considerably better as developing markets have much laxer reporting standards and short-sellers can be much more effective there.
Garbage In Garbage Out principle is applicable here → All the data collected for this research was from the respective company’s official website.
The returns might not be proportional to the drop in stock price. Since a lot of people are expecting the stock price to drop following the short report, the implied volatility of the put option will be high leading to high premiums.

Well, before you jump into shorting stocks based on the next short-seller reports, you should know that it’s not all sunshine and rainbows in the shorting world. Even veteran investors have burned their hands shorting stocks. Famous investor Bill Ackman lost as much as $750 Million shorting Herbalife. Hedge funds have lost more than $20 billion betting against Gamestop and Melvin Capital had to shut shop following the GME rally.

All of this comes down to the fact that shorting stocks is fundamentally an extremely risky strategy with limited upside and unlimited downside. If you can stomach the risks, it’s a great way to make a killing in the market.

While I do think there are some issues with short-sellers as highlighted by the GameStop saga, I believe that they are instrumental in weeding out the bad players in the market. In a market full of optimists, it’s good to have a small bunch of pessimists!

Until next week….

Data: All the data used in the analysis can be found here

Footnotes

I am simplifying the process way too much here. If you are planning to actually do this, do read about the exact process and risks involved.

Imagine having something similar in investing/trading platforms.

Till date is considered June 1st, 2022

Disclaimer: I am not a financial advisor. Do not consider this financial advice.

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