Don't fear shorted stocks, they're great for value investors

Finding out that you own a heavily shorted stock can be daunting, but you're actually in luck. 

It's hard out there for short sellers. While profiting from other people's misfortune has always existed, the global financial crisis brought this tiny group of investors into the spotlight. Company managements hate them; ordinary shareholders fear them; and movies poke fun at them.  

Most investors buy a stock and then profit from a rising share price – 'buy low, sell high'. A short seller, on the other hand, borrows stock from another investor, then sells it and hopes to buy it back at a lower price down the track, before returning the borrowed stock back to the lender – ‘sell high, buy low'. Short sellers profit from bad news and a declining share price.

Some investors have done well shorting stocks (a few of whom we profiled in this special report). However, you may have spotted a flaw in their operation. Imagine that the short seller gets their analysis wrong and the company continues to grow. If the share price rises, those shorting the stock at today's price will be forced to buy back the stock at higher prices to minimise escalating losses. That's why short selling is so risky – in theory, you could face infinite losses, while your upside is capped at 100%.

Nonetheless, short selling is widespread. ASIC produces a daily report on those stocks that currently have short positions against them, which you can find here. More than 450 companies make the list, including big names like Woolworths (ASX: WOW) and Rio Tinto (ASX: RIO). In fact, it's likely that most of the stocks in your portfolio have at least a few short sellers hoping they fall.

We often receive questions along the lines of ‘A stock I own is being heavily shorted, should I be worried?'. Our response is always a firm ‘it depends'.

Short sellers aren't fools, and they usually have good resources to spot industry problems and fraud, so if you find one of your stocks on ASIC's list, it's worth considering what arguments the short sellers have for betting the stock will fall.

Ultimately, though, short selling is just a difference of opinion, what matters is the analysis driving it. Every time you buy a stock, someone is selling it to you who presumably thinks they're getting the better deal.

The hidden benefit

In fact, far from making the job of the value investor harder, short sellers actually make things easier – so long as your analysis is correct.

Let's consider a hypothetical company, which has 15% of its shares held as short positions. The important thing to remember is that this 15% figure is stock that has already been sold.

If the short sellers were to increase their position to 20%, that would cause extra selling pressure in the short term, potentially allowing you to buy at lower prices. If the company continues to grow, the situation for the short seller is akin to holding a beach ball underwater as the tide rises. The pressure builds and eventually they will have to buy back that 15% of stock. Unlike ordinary investors, who can simply buy and hold forever, short sellers are forced to buy back stock if the share price rises too much, otherwise they would face endlessly growing losses.

A stock with a short position against it says one thing: you have guaranteed buyers of the stock at some point in the future. And, if your analysis is correct and the share price rises substantially, they could be forced buyers to boot.

The only time short selling may work against you is when dealing with companies where a negative feedback loop might kick in. If a major bank, for example, were to be heavily shorted and rumours are spread about its solvency, it could undermine its relationship with its creditors, pushing up its cost of capital, which reduces its earnings power and weakens the company – a self-fulfilling prophecy. This happened to several US financial companies during the financial crisis.  

Nonetheless, speculators, volatility and short sellers are all in the long-term investor's best interest because they create opportunities to buy at undervalued prices. So long as you have a firm grasp of a stock's intrinsic value and buy with a margin of safety, short sellers can be a value investor's best friend. 

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