Part of what seems to motivate investors is a desire to make money in the context of working towards their financial goals. However, part of the motivation for many investors is the accolades that come when they get a call right. Think about all the bragging rights when you call a stock out as overvalued! ”Yea, I shorted XYZ stock all the way down. The numbers just didn’t make sense to me.” If you can pull that off a couple times, CNBC will be booking you ASAP. However, does it really make sense to try to short “overvalued” stocks—either from a financial perspective or from an accolades perspective?
Alon Bochman, CFA, of the CFA Institute has some data that should make you think twice.
Valuation shorts have a bad reputation on Wall Street. You may be right in the long run, but you may not be able to hold the position long enough to get there. As David Einhorn puts it, “We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.”
Valuation shorts are a dicey proposition on intellectual grounds, too. John Hempton, who is the chief investment officer at Bronte Capital and publishes one of my favorite investment blogs, puts it this way: “In a valuation short we are working on the same information as everyone else has. This makes me uncomfortable. There is an arrogance in suggesting we can analyze the information better than anyone else. We find it harder to answer the question of what we see when others don’t and hence harder to justify the position at all.”
I was curious whether valuation shorts work as a whole, and have recently had occasion to test this question using a new research service called Activist Shorts Research. They have compiled data on more than 400 campaigns by noted short-sellers from 2002 to the present. The returns look like this:
The mean price change (not including dividends), indicated by the blue line, was −14.2% over an entire “campaign,” which can be arbitrarily long. Additionally, 65% of campaigns were “successful” in the sense that the price of the target stock dropped since the campaign was announced. In 4% of campaigns, the price dropped 99% or more. These figures sound quite good, but it is important to note the sample is biased because the service does not cover all short-sellers, only the “best” and “most public” ones. These two groups likely overlap but not completely.
Despite the biases of the overall sample, the question I was most interested in was whether valuation shorts work better than fraud shorts. For each campaign in the dataset, we have a “Primary Allegation” which is the reason the short-seller used to publicly justify the short call. The reasons provided are many and varied, but I have grouped them into the two buckets we are interested in. The results are stark:
Primary Allegation Fraud Valuation Total Mean Return −30% 3% −14% Campaigns 229 219 448
Short campaigns that allege a stock is overvalued are wrong as a group: the target stock rises 3% over the life of the campaign, on average. Shorts that allege fraud are much more effective: the target stock drops 30% on average. We can see this result in some more detail by comparing return distributions:
My emphasis added. On average, shorting stocks based on valuation hasn’t worked out so well. You might win, but the odds aren’t in your favor. Kind of like Vegas.