If you follow the business press, you’ve probably seen the raucous unfolding story about Herbalife, a company whose share-price has tumbled then oscillated ever since Bill Ackman, the hedge-fund manager, took a short position in the stock a couple months ago. Ackman has alleged that Herbalife is actually a pyramid scheme — i.e., that its revenue primarily comes not from its sale of actual goods, but from its ‘multi-level marketing’ strategy in which its distributors recruit new individuals to sign up as distributors, and take a portion of that sign-up fee in return. That is, Ackman alleges that Herbalife distributors are only making money by taking one-off payments from new distributors, which is obviously not a sustainable business strategy over the long run (how will Herbalife’s distributors make money once all 7 billion people on earth have been recruited, if it can’t make money by actually selling its goods?). Ackman wants the authorities to investigate Herbalife’s business model. Others, like Carl Icahn, have come to Herbalife’s defense, saying that Ackman’s allegations are misplaced and, more, since these false allegations have unjustly driven the company’s stock-price downward, the company is now a very good buy.
This story will, no doubt (as is every story’s wont), continue to unfold. But I wanted to use this opportunity to explain and explore the basic theory of short-selling in financial markets. Short-sellers don’t have a good reputation with the companies they target for short-selling, or with members of the public who think that short-sellers hurt the companies they target or profit from others’ losses or hurt the market. But I want to argue that short-sellers play a very valuable role. This post will have four basic parts: (1) I will explain what short-sellers do, emphasizing that they do not directly ‘take capital away’ from companies, and therefore do not directly hurt them. (2) I’ll argue that we as a society do not want the stock market just to go up and up as high as possible, but, rather, we want it to be correctly priced. In part (3) I’ll combine points (1) & (2) to argue that short-sellers play a valuable role. And (4) I’ll caveat my roseate view, and acknowledge and address some criticisms of short-sellers.
(1) What is short-selling? The basics: Suppose you have a very good reason to think that a stock is underpriced — that, all things considered, it will return more than the market rate in the future. What should you do? Obviously, you should buy it, which amounts to placing a bet on the stock’s rise. Colloquially, we call this ‘taking a long position’ in the stock. Now suppose that, after a few years, other investors fall in love with the stock, and, now, you think it’s overpriced. What do you? Obviously, you sell. But what if you see a stock that is overpriced, but you don’t own the stock in the first place? What do you do? It would obviously make no sense to buy it in order to then sell it — that would just incur two fees from your broker. So what can you do? Is there any way that you can bet on the decline of a stock’s price if you don’t own the stock in the first place (or bet on its decline beyond just selling off all of your shares)?
As you’ve probably guessed…yes, you can short-sell or ‘short’ the stock. How do I do that? Technically, when I short a stock is that I borrow it from someone else for a contracted time and at a contracted price (colloquially, we call this ‘taking a short position’ in the stock). This allows me to profit from the stock’s decline over the period of the contract. Here’s how it works: Say that stock in QWERT is trading for $100 a share. I could pay somebody else $10 to ‘borrow’ their stock for 1 year — if they expect the stock to rise, stay flat, or even only fall a little bit, then this is a great deal from their perspective. Then, I could immediately sell the stock at the market rate of $100. Then, at the end of the year, if the price of QWERT’s stock has declined to, say, $70 a share, I could repurchase the stock at this new, lower price, before returning it to the party I borrowed it from. So I paid $10 to borrow it for the year, sold it for $100, and then bought it back for $70 — I made a cool $20 while effectively investing only $10 of my own money for the year. (Modern markets are sufficiently sophisticated that I don’t actually write up individual contracts to borrow every stock I short — I can do it with a click of a button. But this transaction is legally happening somewhere underneath my click.)
If I’ve belabored this explanation a bit, it’s because I want to make clear a couple of key points: First, a ‘short position’ (just like a ‘long position’) is simply a transaction in secondary financial markets between consenting adult investors that doesn’t directly impact the capital that the company itself can access. A short-sale is the flip-side to any long position in a stock — long investors are gambling that the stock is underpriced, while short investors are gambling that it’s overpriced. What does this mean? Well, first it means that the common financial metaphors that compare short-sellers to sharks and predators are misleading. Short-sellers aren’t hurting other investors without their consent — when you borrow a stock to short it, your counterparty knows exactly what you’re doing, and makes a deal with you anyways, because s/he disagrees with your assessment. And short-sellers don’t directly harm the businesses they target (N.B. I’ll caveat this later). A company gets the equity capital that it needs in order to grow and function from its Initial Public Offerings and other direct share offerings. But as soon as a company sells shares to the public, the money it received on the sale belongs to it. So increases and decreases in the price that those shares trade for in secondary financial markets (i.e., fluctuations in the stock price) have no direct effect on the company’s store of and access to capital. To repeat: The equity that gets traded in secondary financial markets is completely distinct from the equity that is on the company’s Balance Sheet.
So what is short selling? Here’s another way to define it: It’s a legal transaction in which I’m a nice guy who takes the opposite side of two trades, paying a fee to a guy who wants to loan out his share for a year, and selling to a gal who really wants to take a long position in the stock. If I’m lucky, I make a profit on the trades. If I’m not, he and she do. The company’s day-to-day operations are usually completely unaffected by my trade.
(2) What do we want the stock market to do? Some theory: When I was a wee lad, before I understood basic financial theory, I thought of the stock market — as represented by the S&P500 index charted on TV screens and newspaper front pages — as a sort of agentic and determined creature, struggling admirably and valiantly and against adversity to move uphill. The S&P 500 chart was, I thought, a measure of the economy as a whole, and the higher it climbed, the better the world was. And wee-me was not the only one to think this way. Indeed, there’s interesting research at the intersection of cognitive science and financial theory that shows how even sophisticated financial commentators imbue their descriptions of stock prices with normative and agentic metaphors — an increase in stock prices is described as “the market vaulted to new heights,” while a decrease is inevitably written up as “another slip in a faltering market.” The basic metaphor that this language embeds and subconsciously conveys to us is: “The market is a self-willed agent, and it is an excellent thing when it ‘rises,’ and a sad thing when it ‘falls.'”
But this is not actually a rational way to think about the stock market. We don’t necessarily want stock prices to ‘climb’ higher and higher. Rather, we just want stocks to be priced correctly. Why? Well, there’s one very obvious and practical reason, and another less-obvious but more fundamental reason. The obvious reason is that when asset valuations just climb and climb, that causes a bubble, and bubbles usually pop, and cause a lot of instability and hell when they do. Bubbles are bad on the way up and on the way down — on the way up, I look at my stock portfolio and think I’m wealthier than I truly am and spend way too much; on the way down, I get upset about how much wealth I’ve lost and become risk averse and don’t buy enough. But is ‘popping’ the only problem with over-high asset valuations? What if we had a magic-wizard policy that could stop bubbles from popping by banning short-selling, etc., to keep bubbles permanently inflated? Would super-high asset valuations be a good thing in this magical world? Even here, economists would say ‘no,’ because even in this magic world, over-high valuations lead to a ‘misallocation of resources.’
What does this mean? Let’s explore a very simple model. Suppose that I have $100 in savings, which I’m considering investing in the IPO of PetApps.com, a new startup website that sells Apps that help your furry friend keep tabs on what other pets in the neighborhood are up to. (Yes, I’m being derisive.) It’s a ‘roaring’ ‘bull’ market that everyone wants a piece of, driving up equity valuations ‘through the roof.’ I realize that the PetApps.com IPO is overpriced relative to its true, fundamental value, but the market has so much ‘momentum’ that I can cash out of my investment while it’s still moving upwards. Should I invest in PetApps.com? Well, the answer depends on who’s asking the question. From my own selfish perspective, I should — I can make a profit by buying and selling quickly during this frenzy. But from society’s perspective, this investment would be a bad thing. Why? Well, when we say that shares of PetApps.com are ‘overpriced,’ we’re saying that, for their cost, these shares will not earn good returns in the future. In other words, capital invested in PetApps.com will not generate as much value as it would elsewhere; more colloquially, the management of PetApp.com is too incompetent to handle all that money wisely. That means that we would all be better off I invested my cash in some company that was undervalued, or in municipal bonds, or even if I just spent it on a vacation now, which would generate income for airlines, etc.
To generalize this thought experiment: At any given time, we have a lot of good options for what we can do with our money. Given that, we don’t just want to just put more and more value into any particular asset, because that would detract from the money that we could use for the other goods. Rather, we want to price each good correctly; this is what economists mean by ‘allocating capital efficiently.’ We as a society don’t just want company shares to sell for high prices per se during their IPOs — we want them to sell for correct prices, providing the company with exactly as much capital as it can use efficiently.
What about the secondary market (i.e, the buying and selling of stocks that you and I can do through E-Trade after the IPO)? As we noted above, trading in the secondary market does not directly effect the capital available to a company. So does it matter to the real economy? I think so. One way to think of secondary markets is as one big ecosystem that supports the ‘primary’ equity markets of IPOs. That is, primary investors in IPOs only invest in the first place because they are counting on the fact that they’ll be able to cash out by selling their shares, whenever they want, into a liquid market. If they made a wise investment decision during the IPO, investing capital in a company that went on to use it to do something transformative (like Apple), they’ll cash out into rising secondary markets, and make a killing. If they invested unwisely, wasting society’s scarce resources on Pets.com, they’ll lose a lot in secondary markets. Trading in secondary markets thus rewards and punishes investors for making efficient and inefficient investment decisions. It’s the ecosystem that is essentially supporting the basic business of getting good investments into good companies.
Also, companies often sell new share issues, well after their IPOs. Those shares will be sold at a price that reflects the total ‘market capitalization’ of company, calculated as the share price times shares outstanding (i.e., if your total market cap is $100,000, on 100 initial shares, and you issue 100 new shares, your 200 shares should now all sell and trade for $500 a piece, since the total value of the company should remain more or less unchanged). And so the same basic principles apply: We want secondary markets to price shares correctly, not highly, in order to prevent destabilizing bubbles, and to properly reward and punish good and bad allocation of capital. A rising S&P 500 is thus only a good thing if the S&P 500 had formerly been undervalued; a declining S&P 500 is a good thing if it had been overvalued. This is why the normative and agentic metaphors that our financial commentators use for the ‘climbing’ and ‘slipping’ market are problematic and misleading.
(3) Does short-selling help the market do what we want it to do? An argument: So let”s put the pieces of the puzzle together. How do short-sellers help support the economy? Well, the most obvious and commonly cited way is that they help provide ‘liquidity.’ If you want to buy a stock in financial markets, you’ll need to buy it from a seller — often a short-seller. But the more fundamental good they provide is that they help correct over-valued stocks. Recall that a short-sale is only profitable if the stock price actually does end up dropping, as the short-seller predicts. Short-sellers, by entering the market and becoming sellers, increase the for-sale supply of a stock and decrease the demand for it, bidding its price down. Short-sellers also have an incentive to publicly reveal their short position, to persuade other investors to drive down its stock price. Thusly do short sellers correct the prices of stocks that they believe are overpriced. This provides the indirect good of supporting the efficient allocation of capital, as discussed above. And often it has more direct, tangible benefits. Short-sellers have historically been very good — often better than the official regulators — at sniffing out and exposing accounting fraud and large companies. The threat of drawing the attention of short-sellers can help scare management teams (whose compensation is typically tied to the stock price) into behaving, being honest and transparent with analysts, not paying out lots of company cash for ‘consulting’ from shell companies they themselves (the managers) own, etc., etc. Short-sellers may be the best and most effective regulators the market has.
(4) Can there be abusive, harmful short-selling? Some caveats: I’ll admit that my perspective here is generally pretty positive about the value short-sellers provide, and I hope I’ve persuaded my readers to share this general feeling. But I think there are special and marginal cases in which short-selling can be harmful. What are these? The first is, most obviously, when a short-seller is wrong and deceptive about his evaluation of a stock’s true value. Suppose Bill Ackman is completely deluded about Herbalife, and the business is truly sound. If this turns out to be the case, then the stock price will eventually rise again, and Ackman’s hedge fund will suffer greatly, punishing him for his false assessment, and Herbalife will be fine. But what if Bill Ackman, having realized that Herbalife was sound, quietly exited his short position, without telling anybody? He might profit from doing this, since Herbalife’s stock has already dropped a great deal just on his allegations. If this happened, Ackman would hypothetically profit from, essentially, tricking the markets; Herbalife would have wasted a lot of its valuable capital on its legal threats to Ackman, its PR campaign, etc.. The markets would have, in this special case, rewarded the wicked and punished the good. Could this happen? Theoretically, yes, but in practice it’s unlikely. If he did this, Ackman would ruin his reputation and credibility on Wall Street for the rest of his life, which would be very costly to him in the end — so it’s very improbable that he or any other investor of significance would. More, delusion and deception are native to the human condition, and hardly unique to short-sellers. And why should we say that erroneously shorting a stock is so much worse than erroneously boosting a stock?
In theory, as we’ve noted, a short-sale can only profit you if the company’s stock price actually does drop, as your short-sale predicts. So a short-sale does not reward you for just attacking fundamentally sound companies. Are there exceptions to this? One possibility is that there could, in some marginal cases, be powerful self-fulling prophecies. Again, as I’ve emphasized, trading equity and balance-sheet equity are distinct; so short-sellers don’t deprive companies of the capital they need to do business. But my understanding is that for some companies, lending terms and other obligations are tied to their shares’ trading prices. E.g., a company might be required to pay a higher interest rate on debt if its shares fall below a certain price. Or a bank that has entered into lots of derivatives contracts might be required to post lots of extra collateral immediately if its share price falls; posting this collateral could, in turn, force the bank to sell off other assets in a fire-sale, which would hurt its core business, initiating a downward spiral. These sorts of effects can be particularly harmful in major economic or financial crises — and so sound regulation should guard against these sorts of systemic and spiraling risks.
But we also hear this concern voiced outside of crisis situations. Some people worry about more mundane ways in which this self-fulfilling prophecy can work its evil. I.e., there’s a fear that short-sellers put heavy pressure on management teams to pay too much attention to short-term stock prices, which could cause them to lose track of sound management for the long run. Is there truth in this idea? Honestly, I’m pretty skeptical. On the most basic theoretical level, the value of a share consists in a slice of all the future profits of a company — so placing ‘the long-term value’ of a company in opposition to ‘its short-term stock price’ is a false dichotomy. More practically, it seems that it would require heroic skill to take down a fundamentally sound business just by psyching out the management. I suspect that this ‘concern’ about ‘harmful short-term pressure’ from short-sellers is largely mongered by management teams who aren’t very good at what they do, and want some pre-fabbed catch-phrases to take to the press, so that the big bad mean short-sellers will leave their company alone!
(5) Things I didn’t just write: This post has not argued that everything in the financial sector, and our public-policy approaches to it, is a-okay. It has not argued that equity-trading is necessarily the most morally worthy of professions (I will also not say it is particularly morally unworthy). It has not argued that there is no excess of high-frequency trading in the markets. It has not argued that it is no problem that so much intellectual talent in the U.S. is pulled into the financial sector as against, say, engineering or teaching. It has not argued against circuit-breakers to prevent the massive crashes that can come from panic psychology or algorithm-driven trading. It has argued that short-sellers provide a valuable service that is essential to a modern economy, and the language and metaphors we use to describe them are misleading.