Time to pity and respect the short seller

One analyst is leaping to the defence of the short seller – arguing that the blame game comes mostly from emotion

Short sellers have drawn the ire of many, with some claiming they have attacked some Canadian businesses – but one industry analyst says we should abandon emotion and instead be proactive when dealing with them.

Recently there has been a lot of talk about short sellers as they've “attacked” some Canadian businesses. There is often a strong emotional reaction to short-sellers, but we should also have a logical, proactive process for dealing with them.

Pity them and respect them.

“The mechanics of short-selling make it much more difficult than buying companies or ‘long-only’ investing,” says Alex Rasmussen, investment analyst, Empire Life Investments. “When you are long a stock, the winners in your portfolio grow and become more meaningful, making further gains more valuable, while your losers shrink and your losses hurt you less, assuming you don't average down.”

For shorts it's the opposite.

“You start off with your maximum reward of 100% return on your initial position,” says Rasmussen, “but your maximum loss is theoretically infinite as your losers grow in your portfolio.”

This makes shorting a very challenging proposition, even before you consider that borrowing costs generally increase as the position goes down.

“You shouldn't fear short-sellers,” he says. “You should pity them.”

That said, when looking at short-selling in the aggregate, investors should respect the practice.
“As a long-only investor, if you're analyzing a company with high short interest – I'll define that as 10%+ of the float being shorted – ask ‘Why?’” says Rasmussen. “What makes so many people so sure this company is a loser?”

Studies have shown short interest to be a strong leading indicator of future stock performance.

“Not only that, but its explanatory power appears to be independent of other commonly used indicators,” he says. “Put another way - high short interest stocks underperform and low short interest stocks outperform in the aggregate, when looking at the overall market. The conclusions for tactical asset allocation are clear, and there may also be strong implications for stock selection.”