The good side of short sellers

If you were to believe everything you hear, you might conclude that all of the problems on global sharemarkets right now could be attributed squarely to "short selling".

So bad is this practice now perceived to be, that the corporate watchdog, the Australian Securities and Investments Commission (ASIC), has banned it entirely for a month.

Anyone who engages in the practice has, by inference, been labelled a fraud, a cheat or some sort of despicable financial predator. It wouldn't be a complete surprise if short selling were at some point revealed as the cause of climate change, or responsible for the assassination of JFK.

Short selling is, to put it simply, a share trading strategy designed to make money when prices fall.

Short selling as a concept isn't peculiar to the finance world. Many consumers would be familiar with a situation where they place an order to buy something, say from an online retailer, but the retailer does not have the item in stock. The retailer is "short" that item.

The retailer may accept your order (and take your money), and then get the item in so it can be shipped to you in a timely manner. Short selling on sharemarkets has some of the same characteristics.

ASIC's decision to ban all forms of short selling for a month caught market participants off guard. Their mood has not been improved by subsequent statements by ASIC granting relief in some situations and "clarifying" exactly what's allowed and what is not allowed - a situation that seemed to change almost daily last week.

The ban is not expected to be made permanent, nor to be extended beyond the initial 30 days. However, market participants believe there may be significant tightening of the rules and regulations on how short selling may be undertaken.

We know how to make money when share prices are rising: buy low, sell higher. Short selling involves selling high and buying lower. To some it is the devil's work, but to others it is simply a market efficiency mechanism.

"People are motivated to make money," says Roger Montgomery, managing director of boutique fund manager Clime Asset Management,

"One way they can make money is to [short] sell the shares of a company that they believe is fundamentally at risk of declining in price.

"The 'problem' is in the company itself, not in the short selling. The problem is [companies] overborrowing to pay for assets, which erodes the balance sheet and makes the company worth less. Prices tend to follow value. Ultimately, if a company performs poorly, people who have bought the shares will sell to people who are not willing to pay as much. The price is still going to fall."

Banning short selling is less a comment on the practice itself than a way of ensuring the efforts of central banks and regulators to stabilise prices are not undermined, Montgomery says.

He agrees with the steps taken to bring order to markets, but says it's wrong to make short selling some kind of scapegoat.

"Short selling is no more evil than 'program trading', which was blamed for exacerbating the 1987 market crash," he says. "[Short selling] is not the real problem - the real problem is a combination of greed and leverage."

Essentially the rationale for all short selling is the same: an investor (the term is used loosely here) believes a share price will fall, and they want to profit from that price movement. It can get a bit confusing when other terms, like "covered" and "naked" get thrown into the mix.

The native Investment Management Association (AIMA) - the industry body that represents, among other entities, so-called hedge funds - says the basic difference between a "covered" short sale and a "naked" short sale is that a "naked" short sale occurs where the seller does not own and has not borrowed or made any other arrangements to borrow securities at the time of the sale, but intends to purchase or borrow securities in order to meet their obligation to deliver the securities to the buyer on time.

In very general terms, a "covered" short sale is one in which the seller has made some form of arrangement for borrowing securities or otherwise meeting its delivery obligations.

A "covered" short sale occurs when the investor can physically sell shares they believe will fall in value. Usually, these shares are borrowed from a third party. That third party might be a superannuation fund, a life insurance company, a bank, or any entity prepared to "rent out" shares that it owns. The investor pays the lender a fee for borrowing the shares, and undertakes to return the shares to the lender when the short selling strategy is completed.

The investor then sells the shares on-market. Let's say an investor borrows 10,000 shares, which they sell for $5 each. That's $50,000 in the investor's pocket (not counting tax, brokerage costs, and so on) on day one.

Over the course of the next few days, let's say the share price really tanks - the investor was right, or perhaps the very act of selling their shares drives the price down - and the investor is able to go back into the market and buy 10,000 shares for $4 each. That's a cost of $40,000.

Having realised $50,000 on the sale and spent $40,000 on the purchase, that produces a $10,000 gain - again, ignoring tax and costs (including the cost of of borrowing the stock). The investor returns the 10,000 shares to the lender, and the short-selling strategy is complete (or "closed out").

A "naked" short sale works in much the same way, but the investor does not own, nor borrow, the shares to be sold. (A condition in this example is that the transaction takes place in the shares of a company on an Australian Securities Exchange (ASX) approved list, and through a broker that specifically facilitates naked short selling.)

The rationale for the trade is the same - that a share price will fall. But it is naked short selling that is thought to have created the bigger problems in equity markets and has prompted the hardest regulatory crackdown. Because the investor does not borrow the shares they short sell, there's theoretically no limit on the size of the trade they can make.

This can have a significant effect on the share price of the company whose shares are being traded. Obviously, this influence can be abused - and it's these abuses that regulators are keen to stamp out. The plunge in the share prices of companies such as Babcock & Brown and ABC Learning are attributed - in all or in large part - to voracious short selling (and by margin loans held by the companies' directors, which forced them to sell shares as the prices plunged).

Greg Hoffman, research director for The Intelligent Investor, says short selling is "essentially the process of selling a stock that you do not own, with the intention of buying it back later, at a lower price".

"It was a very profitable strategy when they were doing this to Babcock & Brown and ABC," Hoffman says. It's not a strategy he uses as a long-term investor, "but certainly it has a place in markets".

"I think speculation is completely legitimate," he says. "It provides liquidity, and if it wasn't for speculators willing to take short-term bets, the market would not function as well.

"Playing my long-term view against their short-term views has worked out very nicely for me over the years."

Short selling is "a legitimate activity, and nobody complained when markets were booming and short sellers were losing a fortune", Hoffman says.

Banning the practice will have ramifications and "unintended consequences that I don't think the regulator has thought through".

"To ban it overnight, we were gobsmacked," says Hoffman.

Montgomery says short selling can be used for more than speculative purposes or just punting on a share price - it can be used as a tool to arbitrage differences in companies' share prices.

"It's how Warren Buffett has made money for four-and-a-half decades," Montgomery says. "No one would say he is evil."

Montgomery cites a hypothetical example he calls "post-announcement arbitrage" where Company A seeks to make a scrip bid to acquire Company B.

"It may be that Company A's bid values Company B's shares at $2, but the shares of Company B are trading on-market at $1.80," Montgomery says.

"We would buy Company B shares, and sell short Company A shares. When the transaction is finalised we would receive Company A shares, which of course we would deliver against our previous short position.

"Initially we are long Company B and short Company A. We then sell Company B shares to Company A [in the takeover], which closes our position in Company B, and the shares we receive in Company A by accepting Company A's bid we deliver against the initial short position.

"At the end of the adventure we have no shares in Company B, no shares in Company A and, when annualised, a very attractive cash profit."

Montgomery says the ban on short selling was "necessary in the face of what the US has done - I agree it's necessary - but the intrusion into the marketplace has reduced the efficiency of the market".

"When you remove a layer of selling in the market, it's Economics 101: reduced supply of something means its price goes up. When you remove short sellers, there's fewer of them, so prices tend to rise."

AIMA says it is concerned a regulatory knee-jerk reaction to the perceived problems caused by short selling may affect Australia's reputation as a sophisticated and open financial services market.

"While AIMA is supportive of regulators' efforts around the world to restore stability to financial markets, we are concerned this total ban on short selling in Australia may actually have the opposite effect," AIMA Australia's chairman, Kim Ivey, said in a statement last week.