The danger of short selling

By Larissa Fernand |  09-02-21 | 
 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

Short selling or shorting involves selling an asset you don’t own to make a profit from the fall in its price. If it is a stock, you are betting against a company. Instead of buying its shares and hoping their value rises, you take a reverse position whereby you profit if the shares fall. However, you could also short a commodity or currency.

Thanks to GameStop, there are plenty of enthusiasts who have discovered short selling and want to get their hands dirty, so to speak. But senior editor James Gard reminds us that short sellers can come a cropper too.

Way back in 2019, he had spoken to James Clunie of Jupiter Absolute Return Fund. Clunie had told James Gard that the theory behind short selling is relatively straightforward: “It’s simply the expression of a negative view on the price of an asset.”

Here’s Clunie’s story. He was well known for his short position in Tesla. He had told James Gard that he looked for companies that were overvalued or whose shares could be about to fall - what he called a company’s “fragility”. He based it on fundamental analysis of the company’s finances: “I have an idea of what it’s worth and why it should go down.”

He had described Tesla as both a “trading story” and a “fundamental story”. The first part meant that he could take advantage of the flurry of ongoing news coverage on Tesla – for example, he added to his short position after the company missed estimates in its second quarter results and shares fell 13% in one day. The “fundamental” view was that Tesla is overvalued, having been through the company’s accounts.

In January 2018, Clunie wrote in detail about his short on Tesla. 

On paper, Tesla looks like a perfect stock to short.

  • The company rates poorly on a number of quantitative screens: balance sheet, quality, asset growth and accounting standards.
  • There are worrying metrics when it comes to the stock’s valuation (such as the high price to book and negative ROE).
  • The company recently reported its largest ever quarterly loss, and has been burning through cash at an estimated $16 million per day. Tesla has only had two profitable quarters since it was listed in 2010.
  • The company has been failing to deliver its new Model 3 cars on schedule. 

Clunie was smart enough not to turn a blind eye to the appeal and storytelling prowess of Tesla’s charismatic CEO Elon Musk.

Musk has been known to use Twitter to seemingly intervene in opinions about Tesla’s stock price. In April 2017 he taunted short sellers in the stock at a time when Tesla’s market cap had eclipsed that of Ford Motors, tweeting “Stormy weather in Shortville…” In July 2017, he used Twitter to “reframe” a negative statement he made about the stock during an interview. In this he hinted that the stock could be under-priced “if you believe in Tesla’s future”. Belief appears to be a key factor in the battle between fundamentals and storytelling. 

Later that year, The Economist echoed the similar sentiment when it wrote that some of Musk’s tweets are targeted at short sellers. With a quarter of its publicly traded shares lent out to facilitate short sellers’ bets, Tesla is one of the most heavily shorted companies in America. Musk has publicly feuded with short-sellers for years, calling them “haters”, “jerks” and “not supersmart”.

Despite James Clunie’s bet having the virtue of reasoned logic, it backfired. Even thought he remained controversially convinced that the soaring stock prices were not based on fundamentals, it did not come crashing down.

January 2020: Clunie has spent £7.9 million betting against Scottish Mortgage, £16.5 million against Amazon, £3 million against Ferrari, £23.5 million against Netflix and a £32.6 million bet against Tesla. He also shorted Chinese electric vehicle maker Nio.

December 2020: Clunie resigned following a sustained period of underperformance (resulting in punishing outflows) after his short bets did not play out.

That year he had told Morningstar: ““What I’ve done is what I call ‘sensible’ stuff and maybe that’s my weakness: it’s too logical, it’s too evidence-based, it’s too sensible.””

Citiwire reported that the fund shrunk from £1.2bn to £165m. In his case, he truly played out John Maynard Keynes famous words, markets can remain irrational longer than you can stay solvent. 

Should you? 

In short selling is not for the faint hearted, I explained how it works. Sarah Newcomb, director of behavioural finance, tells investors to speculate only with money you can afford to lose. “If you are new to investing and don't understand the difference between fundamental value and market price, this is not for you. If you are considering putting money on the line that you need for your present or future security: stop, breathe, and walk away. Don't put your life savings on the line trying to guess what the herd will do next. If you can't afford to be wrong, don't make the bet.”

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ninan joseph
Feb 12 2021 06:16 PM
 Don't put your life savings on the line trying to guess what the herd will do next. If you can't afford to be wrong, don't make the bet.

Yes fully agree. This article has come out at the right time. After the Gamestop stock, all wants to play this new game. The loss is unlimited.
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