Can attacks on stocks by short-sellers ever be beneficial for the victim?
Short sellers are often accused of market manipulation and exacerbating economic inequality. Short bets are also perceived to be 'against the common investor' as the zero-sum game nature of the stock market may affect the positions held in long-only pension or insurance funds. Hedge funds, which may see short-only strategies as more lucrative than traditional equity long/short or arbitrage strategies, require large capital requirements, attract wealthier clients and pursue riskier trades via synthetic leverage to reap greater rewards. However, short-interest could remove the management's corporate myopia and allow a realignment to shareholders' environmental and social objectives as well as behaving as an investment tool to avoid future short attacks and the potential for large losses.
Increasing coverage around short-sellers betting against stocks with positive ESG credentials has been due to questions over the greenium and the value in sustainable investing. However, shorting stocks with poor ESG profiles, particularly environmental, goes unnoticed. This trend may be a consequence of the global macroeconomic situation from squeezed supply chains and elevated commodity prices and the need for non-renewables at present.
Fashionable Shorts
The justification behind shorting 'green stocks' is not because short sellers believe these companies will become insolvent. Instead, they see PE multiples as unreasonably elevated or EPS growth as unsustainable given the speed to which firms can increase production. One short-selling campaign was directed at Beyond Meat, which IPO'd in 2019's deal boom and was one of the first multinational vegan brands to go public, investors now argue the IPO was premature. Beyond Meat downgraded Q3 revenue projections and signalled towards debt raises despite expanding its global marketing campaigns. Q3 losses from operations were $54.8M tripling from the year prior due to an increase in overall headcount. Growth in plant-based meat consumption in supermarkets has stagnated. Hedge fund manager Jim Chanos of Kynikos Associates took a stake in $40M worth of put options contract in late 2020 against Beyond Meat. Since then, utilisation, the number of loaned shares divided by the shares available, has risen to 94% and the stock price has dropped almost 70%. January, through Veganuary, is a popular month for synthetic meat companies; it will be interesting to observe the subsequent trading update.
In addition, the rapid growth of certain sectors such as cannabis, crypto and electric vehicle startups have been plagued with product fraud or misinformation accusations by hedge funds. Among these, cannabis producer Trulieve was under pressure by a short researcher around their cultivating facilities explaining that their product was low quality and sensitive to infestation and weather; the stock price cratered 50% two months after the report was released. However, it has since turned the tide and increased over eight-fold from the low. Some of these allegations have led to formal US government investigations. Half of the ten most shorted stocks as a percentage of float are health or EV-related companies.
Conversely, hedge funds have invested in undervalued carbon-heavy stocks such as oil and coal recognising the necessity for non-renewables during the current energy crisis, particularly in Europe coupled with the Russia-Ukraine crisis. The relaxation of restrictions in Asia after Omicron increased pressure on health services has also fuelled energy demand. Amid the pandemic rebound, the net profit that may have been used for future physical capital investment was into generous share buyback and dividend programmes. These actions have led to inflexibility, supply-side bottlenecks and input price pressures. However, a note by Citi earlier this year that CAPEX could rise by 30% this year alongside a pickup in private activity which will reduce upside price potential; publicly run oil firms remain inert.
As an Investing Tool
Many argue these funds have greater benefit encouraging carbon-reliant firms to move to greener alternatives by exposing their sensitivities to raw material scarcity. By shorting stocks, criticising how firms operate, hedge funds could influence managerial behaviour. Corporate boards and management suggest rewards are needed from GHG-emitting projects for reinvestment in greener technology. Shell CEO Ben van Beurden said that the oil 'legacy business' should be used to finance the green revolution. This is greenwashing, Shell's cash reserves are a whopping $38bn as of 2021 Q3, doubling in less than two years and oil prices are expected to remain at record highs, some analysts predict 2022 price targets as high as $150. In an ideal world, firms should be priced accounting for the external costs they produce, however, this social pricing strategy may not be profitable.
Short interest, which is non-aggressive, often foreshadows short attacks. Once one hedge fund decides to make its findings publicly available, markets reprice. Activist hedge funds who publish their findings influence management by exposing fraud in balance sheets, this is usually performed in the US given the stringency of EU disclosure laws, namely the market abuse regulation (EU MAR). Short attacks have provoked replies from the company's management. Often, the larger the company, the scandal and their interactions with average consumers the more traction the research gains and the quicker the firm becomes insolvent if allegations are proven to be true, such as the 2020 Wirecard scandal. In the long run, this is good as the company is likely to continue to commit fraud, money laundering or window-dressing their balance sheets and cash flow statements. Luckin Coffee, a coffee brand attempting to dent Starbucks' market share in China, was a victim of an aggressive short-selling attack by Snow Lake Capital, Third Bridge and two consulting agencies. These firms brought attention to inflated sales, which eventually led to the company's self-confession of fraud and a consequent delisting. Now, Luckin Coffee aims to look to relist after reforms.
If a company reacts to a short-selling attack constructively, the stock could be repriced positively, creating losses for the short position. However, the average short-holding duration by hedge funds is only 50-days, implying that hedge funds somewhat expect an increase in awareness and resolution of the issues highlighted in the attack, but the strategies are profitable initially. Non-aggressive strategies are likely to prove less effective than aggressive strategies. Non-aggressive strategies risk short squeezes heightened by increasing US regulation around the transparency of hedge fund positions and performance, Melvin and Light Street Capital experienced a short squeeze in their GameStop positions.
Given its ability to foreshadow future downside short interest should become a traditional filter for stock picks similar to financial ratios. Hedge funds that provide research services take positions within stocks, which is stated as short interest before publishing their research. Conclusively, short interest can be used profitability in the short term and constructively, such as in the case of Luckin Coffee, in the long term.
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