The Perils of Short Selling

In his article about the new ban on short selling 800 US financial stocks, Larry MacDonald discussed some of the pitfalls of short selling. This reminded me of one of the more interesting ways that short sellers can come out on the losing end.

Short selling is the practice of borrowing stock and selling it so that you effectively own a negative number of shares. Short sellers hope that the stock drops so that they can later buy the stock back at a lower price, pocket the difference, and return the borrowed shares. Until recently, this practice was perfectly legal. Now, short selling is banned on certain beleaguered financial stocks.

As Larry said, the biggest reason why short selling is a difficult game is that stocks tend to go up. When you pick a stock to short, you have to have far better insight into the stock’s future than other investors just to break even. Using short sales to make more money than you could have made by simply owning an index is very difficult. Some might say that it’s a fool’s game.

Even when you are right about a business being overvalued, you may not make money. Government interference to prop up stock prices or ban short selling are possibilities. Another possibility is the stock remaining overvalued for years until the business value finally catches up to the stock price.

One of the more interesting ways that overvalued businesses cheat short sellers occurred during the tech boom. Suppose that ABC stock trades for $100, but ABC’s business is really worth less than $1 per share. This would seem like a perfect situation for a short seller.

But, what happens if ABC makes an acquisition? Suppose that ABC doubles the number of outstanding shares to acquire another business that is fairly valued. Now the true value of ABC’s shares has jumped to about $50 each (that is $100 of value in the acquired business spread across twice as many ABC shares). In the mania of a bubble, this might cause ABC shares to jump to $300 each.

Now ABC repeats the process by finding another larger business to acquire that matches ABC’s new larger market capitalization. Again, ABC doubles its share count. The new business value is $50 from the first acquisition plus $300 from the new acquisition diluted across twice as many ABC shares. Now ABC shares have a fair value of (50+300)/2 = $175.

ABC has successfully used its overvalued stock to increase its real value by over two orders of magnitude. Imagine the poor short seller who sold ABC stock for $100 before the two acquisitions. He thought he had a sure thing because ABC was overvalued by a factor of more than 100. Now ABC stock is worth at least $175 per share, and the stock is likely to trade much higher than this because of the mania. Short selling is a difficult game.