Investigative Short Sellers: The Antiheroes of Financial Markets
Who they are, why they matter, and why they're hated by some and revered by others.
“Buy low, sell high,” is an adage you’ve probably said at some point in your moderately-financially-literate life, maybe in the context of lecturing another moderately-financially-literate person about his or her poor investment decision. The age-old investing truism is, of course, much easier said than done. But the notion that a basic way to make money is by buying something for price x and then turning around and selling that thing for something greater than x is a concept so intuitive that you’re probably wondering why I’m even mentioning it.
Buying low and selling high, as simple as it sounds, is the backbone of the traditional investing community. Read Investing for Dummies or books by famed investors like Benjamin Graham or Warren Buffet, and you’ll be instructed to invest your money in companies that run businesses you think provide society with useful, sustainable and long-term goods and services. Those books will tell you to hold on to those stocks for years, even decades, and watch them appreciate in value. Then, once you’re old and gray, you can sell your stock in Apple, Coca-Cola and Walmart and retire in Miami or some other god forsaken place.
One, maybe less intuitive, reason why this approach of buying things we like at a relatively lower price, holding them for a while, and then selling them once they’ve risen in price makes sense is because of a phenomenon we talked about in a different context last week: asymmetry. When you buy something (say, for $10) and hope it goes up in price, you have what’s known as asymmetric upside—that thing could theoretically appreciate in value to $1,000,000 (or more!), but the lowest it can go is $0. According to the conventional wisdom espoused by traditional value investors, asymmetric upside is what it’s all about.
But, just like the people who pour milk in before the cereal, there’s a group of people out there who choose to buck conventional wisdom by buying high and selling low.
Meet Hindenburg Research, one of a niche group of research-focused activist short sellers making big bets that the stock prices of certain companies will go down in value. Think of Hindenburg as the illegitimate love child of an investigative journalist and a hedge fund. Like an investigative journalist, Hindenburg and others like it spend months, sometimes years, diving deep into a company it suspects is guilty of some sort of corporate malfeasance like accounting fraud or lying to the public about a material aspect of its business. They talk to sources, scour troves of public information and travel far and wide to visit factories in foreign countries—all for potential evidence of corporate misdealing that the company has been shielding from the public or that the general investing community may have simply missed. Distilling all of its research, the investigative short seller then prepares an exposé, detailing its findings about the company’s illicit conduct.
But like a hedge fund, the investigative short seller will, often in the weeks leading up to the publication of its report, build what’s known as a “short position” in the company’s stock—basically betting that the stock price will drop by borrowing someone’s (let’s call him Jim) shares in that company and then selling those borrowed shares to Jane, hoping that the stock price will drop so that the short seller can buy back the shares it sold to Jane at a lower price and return them to Jim, leaving the short seller with the difference between the price it initially sold the stock to Jane for and the price it paid Jane to buy the stock back. But this is a dangerous game not for the faint of heart—just as buying low and selling high offers asymmetric upside (potentially limited losses but infinite gains), short selling offers asymmetric downside (potentially limited gains but infinite losses).
Once the investigative short seller has built up a sufficient short position, it releases the scathing report hoping the news will tank the stock, at which point, if all goes to plan, the short seller closes out its position and goes home with a pretty penny.
Hindenburg has been in the news recently for dropping its latest report, this time targeting Gautam Adani (one of world’s richest people) and his multinational conglomerate based in India, Adani Group. The 200-page report, Adani Group: How The World’s 3rd Richest Man Is Pulling The Largest Con In Corporate History, is the product of a two-year investigation by Hindenburg that uncovered a decades-long “brazen stock manipulation and accounting fraud.” The ramifications of the report were substantial—the stock immediately dropped over 18% after the report’s release, only to plummet another 43% days later after Adani released his own behemoth of a report (a trim 413 pages), which Hindenburg promptly responded to hours later. And while the Adani Group’s stock price has rebounded slightly, the damage, at least from Hindenburg’s perspective, has already been done—Adani’s reputation has been called into question by regulators and the general investing public, and Hindenburg has likely already closed out its short position by buying back the shares it sold to Jill, and returning them to Jim, yielding what we can only presume to be a handsome sum.
Adani is the latest in a series of targets that Hindenburg, and other investigative short sellers like Citron Research, Viceroy Research and (my personal favorite) Muddy Waters Research have sought to unmask as corporate fraudsters of varying degrees and kinds and turn a profit in the process. Luckin Coffee, Wirecard, Lordstown Motors and Nikola are just a few recent examples of companies that were nearly bankrupted (or, in the case of Wirecard, actually put out of business) by investigative short sellers who put forward a compelling case of corporate fraud out in the public for their own financial gain.
If this all seems quite loathsome and reprehensible to you, you’re not alone. Even though today’s “investigative” short sellers are a relatively new phenomenon, short selling generally has been around since the advent of the first stock markets centuries ago. Napoleon actually outlawed short selling in the lead up to the French Revolution, calling it “unpatriotic” and “treasonous” to bet against the wellbeing of the government and the country’s businesses. Recently, although lacking in the same spicy rhetoric invoked by Napoleon, the SEC unveiled its own proposed rules to increase oversight and transparency in the world of short selling by collecting and disclosing aggregate holdings of short sellers.
There are reasons to be concerned with this practice. In 2021, the DOJ subpoenaed almost 30 firms engaging in investigative short selling, requesting internal communications, calendars and other records. Core to the SEC’s concern was that some investigative short sellers were publishing inaccurate or misleading reports in an effort to stoke market fervor and turn a quick buck before the stock rebounded (called “shorting and distorting”). A study by Columbia law professor Joshua Mitts—an advocate for reform of the laws covering investigative short sellers—examined more than 1,700 reports made by pseudonymous short sellers from 2010 to 2017 and found that the mostly baseless reports published by anonymous online contributors resulted in about $20 billion of “mispriced” stocks because of adverse and unwarranted market panic. And although nothing (at least publicly) has come from the SEC’s 2021 probe, one recent example of an anonymous, fairly small potatoes, short-seller who was forced to reveal his identity and ultimately settle a lawsuit with a company for publishing a a false and misleading article that triggered a 39% drop in the company’s stock price should serve as a cautionary tale for these investors.
But, beyond the publication of false or misleading reports, which is plainly fraud and market manipulation, some are even concerned about the publication of genuine reports by short sellers. One of the primary arguments isn’t too distinct from how Napoleon felt back in the day: Short sellers are just not the kind of actors you want in society, and publishing reports in the hopes of profiting off a company’s demise is inherently bad. After all, the vast majority of us are “long” stocks—if you have a basic stock portfolio, own the S&P 500 index or even just have a 401k, you want stocks to go up, not down. But if the underlying corporate conduct of an individual company is truly fraudulent (think Enron, which was exposed by short sellers), then wouldn’t we want to expose those bad actors in an effort to hold companies accountable and generally incentivize good conduct among the rest of the corporate world? Wouldn’t that sort of make the short seller the good guy?
Another criticism is that these short sellers are fundamentally tapping into an inherent propensity we have to focus more on the bad than the good. Negativity bias (the cognitive bias that we feel negative events more intensely than positive events of the same magnitude) and loss aversion (the pain of losing feels psychologically twice as powerful as the pleasure of gaining) are two well-known effects that short sellers effectively leverage to disseminate reports and drive companies’ stock prices down. But this is more an indictment on the media landscape at large than short sellers in particular. After all, the media is much more likely to cover, and people are much more likely to read, a story about Nikola’s fake electric truck ad than a story about how great of a quarter Nikola had.
Then there’s the notion that a short seller has some sort of “conflict of interest” by virtue of putting out a negative report on a company that it openly maintains an active short position against. While I guess this is technically a “conflict,” this argument doesn’t really pass muster because (1) if fully disclosed, the public reading the report should be able to factor in the short seller’s position as a variable in their decision to sell the stock, and (2) more importantly, doesn’t basically every public-facing investor have this kind of “conflict of interest,” just usually on the upside rather than the downside? When Warren Buffet touts how great of a business Bank of America is, or when Cathie Wood (with a straight face) describes her base case for Tesla as $4,600/share by 2026, aren’t those the same kinds of conflicts? What about that Columbia law guy we mentioned earlier, Professor Mitts, who discloses in his paper that he consults on these issues, including for companies that were targets of activist short sellers. How is that any different than short sellers disclosing their short positions?
To be fair, there are more nuanced and pragmatic criticisms, too. In 2020, our pal Professor Mitts and some of his academic buddies filed a petition with the SEC to propose a rule:
Requiring short sellers to disclose to the public when the short seller has changed its position in the stock or exited it altogether; and
Clarifying that rapidly closing a short position after publishing a report, without having specifically disclosed an intent to do so, can constitute market manipulation in violation of Rule 10b-5.
These are fairly innocuous and reasonable suggestions. If the ideals of short selling are truth-seeking and transparency, then we should hold short sellers to the same standards. That said, Mitts has also endorsed more draconian rules that would restrict short sellers from closing out their positions for a period of time after publishing a report, an impractical and overly-simplistic proposal that has garnered a fair amount of criticism.
Fundamentally, broad-based criticisms of these investigative short sellers are largely misguided. You may be skeptical, or outright reject, the argument that these are truth-seekers fighting the good fight by weeding out corporate malfeasance, but there is at least something to be said for their record of uncovering some of the largest corporate frauds in history. And whether investigative short selling is actually good business and a sustainable way to make money is also up for debate. But one thing you can’t deny is that these short sellers certainly have skin in the game. In a sense, by taking such large and risky bets, they are kind of like the ultimate investigative journalists. They build a short position that, at least in theory, has asymmetric downside risk, release a report stating their findings, and then hope that the weighing machine that is the stock market digests the report and rules in their favor. Show me a journalist that puts her money where her mouth is like short sellers do. At a basic level, then, if a journalist is only as valuable as the newsworthy stories she is able to break, then what’s the difference between an investigative journalist and an investigative short seller (other than, if all goes well for both of them, a few more zeros at the end of one of the two’s paycheck)?
very informative!