8 minute read
Leverage Short Reports, Don’t Fear Them
Written By
Alexei Rogatkin Short reports have been a prevalent part of the stock market for decades, but have notably become more common over the last several years. There were an average of 2.5 reports per year between 1996 and 2009, but that number has grown to a whopping 35 reports per year from 2010 to 2018. As such, navigating the muggy waters of short reports is an increasingly important skill for investors, both institutional and retail. Short reports refer to when a short-selling institution releases a document detailing their reasons to short sell a stock. These reports often drum up negative speculation among investors, leading to a sharp drop in the stock prices of the companies in focus. On the other hand, many investors rely on such price drops to buy stocks at a discounted price. Thus, short reports create opportunities and carry inherent risks that make analyzing these companies challenging. On Wednesday, October 7, 2021, Scorpion Capital -- one of the most notable short selling institutions in the United States -- released a report on Ginkgo Bioworks (NYSE: DNA). In this “harshly critical” report, Scorpion called Ginkgo a “colossal scam, a Frankenstein mash-up of the worst frauds of the last 20 years.” Unsurprisingly, in response to the report, Ginkgo’s stock price fell from almost $12 to $9.47 in just four days. A steep drop in price represents one side of what is called the “short report debate”: the push and pull of investors’ reactions to short seller reports. Cathy Wood, a notable institutional investor, exemplifies the other side of the debate. Ginkgo is a stock that Wood backed heavily leading up to the short report. Wood, however, did not flock away from Ginkgo following the short report; she doubled down on it, buying over 8 million shares for her funds. Interestingly, from Monday, October 11 to Tuesday, October 19, Ginkgo’s stock price skyrocketed from $9.47 back up to $14.81. DNA now sits at $12.97, holding relatively constant since the short seller report. Many investors lost millions of dollars, but if an investor timed their purchase correctly, one could have grown their investment by over 50% over the course of a few days. As such, the “short report debate” continues to rage on as short seller reports get released. Although most investors see short-seller reports as a signal to avoid or short the attacked equity, short seller reports create buying opportunities depending on who releases the report, the response of the attacked company, and the characteristics of the attacked equity.
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Since short sellers hold the equities that they report on, the short-seller has a monetary incentive to make the equity appear fundamentally overpriced. In some cases, short
sellers use smear campaigns to drive down the stock price, thus profiting as the price drops by shorting the equity. “Short and Distort” (S&D) is one tactic that results from these monetary incentives. S&D traders can manipulate stock prices by buying short positions or fast-expiring put options, followed by a smear campaign to drive down the price of the targeted stock. This is the mirror image of the better-known “pump and dump,” where investors promote speculative stocks before selling their positions at the top. S&D campaigns cause investors to flock away from the targeted equity, thus driving down the share price. With these monetary incentives for short sellers, it is clear why some short reports are not accurate and are part of a bigger smear campaign to gain quick profits. Furthermore, “cases against short sellers are rare… given free speech protections and companies hesitant to put themselves under the microscope of regulators,” according to Activist Short Selling research. Although investors’ initial reactions to short reports are to sell their positions and stay away from the attacked equity, short reports can actually create opportunities to buy fundamentally sound stocks at heavily discounted prices. Navigating short seller report credibility is often difficult, but company fundamentals can help investors with long positions mitigate their losses. Two of the most common characteristics of firms on the stock market are overvaluation and uncertainty. Overvaluation has been a common theme during the strong 2020 - 2021 bull market, with many stocks trading at multiples never seen before by the marketplace. Some common themes among these stocks are high P/V ratio, high asset growth, and price run-ups. With the surge in SPACs over late 2020 into early 2021, investors have seen many uncertain SPACs thrive and others crash and burn. Highly uncertain stocks have features such as low accounting quality, few dedicated institutional investors, non-Big Four auditors, and internal control weaknesses. A 2017 study compared uncertain and overvalued stocks and their price responses to short seller reports. Short sellers typically target firms that have both uncertainty and overvaluation features because of several reasons. Uncertain companies have an investor base that is easily influenced because investors are not sure how precise company information is. This creates an environment where investors flock away from uncertain stocks if presented with new information from a short seller report. Short sellers target overvalued firms because they have a higher likelihood of a large price drop. However, some short seller reports target either overvalued or uncertain stocks, and investors can use this information to help navigate the short- and long-term stock market reactions.
Short report. Source: Yahoo! Finance
10/7: Scorpion Capital Releases Short Report
Depending on the characteristics of the attacked equity -- overvaluation or uncertainty -- the stock price reacts in different ways over the short- and long-term. For investors with long positions on overvalued stocks, long-term losses depend on overvaluation features more than short-term losses. Because of the nature of overvalued companies, long-term losses reflect firm fundamentals captured by overvaluation features. For example, if a stock is overvalued and a short seller releases a report, the stock is likely to reset to its expected valuation or lower -- and the chances that it recovers back to overvalued prices is less likely. On the other hand, short-term losses for investors with long positions depend more on uncertainty features. Given the nature of the investor base for uncertain stocks, investors are more likely to flock away from an uncertain stock in the short-term if presented with new information from a short-seller report. However, the uncertain nature of the stock gives it the opportunity to recover over the long-term. Finally, the 2017 study finds that short-selling cases covered by media or initiated by reputable short-sellers lead to more negative returns. Investors, then, should deeply analyze who released the report and its media coverage when deciding whether to buy more, hold, sell, or short their stock. After analyzing the fundamentals of both the attacked equity and the short seller, investors should consider the attacked company’s reaction to the short report. The attacked equity’s response, together with the initial stock market reaction, is an indicator of the credibility of the short report. One study looks at over 350 short seller reports between 1996 and 2018 and the associated reactions by the attacked equity and stock market. In their sample, 31% of firms respond through a press release, conference call—providing additional information to investors—file or threaten lawsuits against the short seller, or launch investigations through an outside counsel. The attacked firm’s reaction to a short seller report can be an indicator for the final outcome of the stock price. Firms with subsequent fraud findings following short reports are much more likely to launch internal investigations and much less likely to make statements that could create additional liability for the firm. These firms are also twice as likely to be delisted and are acquired at a rate less than 50% compared to the overall sample, and thus have more negative stock price outcomes. Investors, then, should carefully look at a firm’s response and deeply analyze any statements in response to the report. Lawsuits against short sellers, on the other hand, usually occur in the most severe circumstances -- when the accusations have the most negative impacts on stock price. These lawsuits are a result of the initial stock market reaction, rather than a mitigant. Lawsuits can mitigate long-term decreases in stock price, but have little utility in the short-term. Since lawsuits are costly and put companies under a microscope, they are usually a response to a severe drop in stock price. Both internal investigations and lawsuits can be negative indicators for firm outcomes in many cases. On the other hand, nonresponse is associated with more muted stock price response to the report release and fewer adverse outcomes. Thus, nonresponse and public statements are oftentimes the most positive indicators of stock price responses and risk. Short reports can suddenly change investor sentiment, so navigating the muggy waters created by short seller reports is an increasingly important skill. Although short reports are traditionally seen as indicators to flock away from the targeted stock, institutional investors like Cathy Wood show how to increase returns by taking advantage of opportunities presented by these reports. Investors should first look into the short seller that released the report, and analyze the potential for a short and distort campaign intended to generate quick profits. Next, firms should review the features of the attacked company and if they are overvalued, uncertain, or both -- as these can be indicators for short- and long-term returns. Finally, investors should analyze the responses of attacked firms, and whether they choose to launch an internal investigation, sue the short seller, issue a press release, or simply not respond.
