A couple weeks ago, there was a little-noticed headline that the Department of Justice is launching an investigation into short selling. The stated reason for this is highlighted in the tweet below:
They are taking down the big, bad hedge funds! And if this idea of hedge funds short-selling sounds familiar to you, it's probably because it was covered ad nauseum during the summer, mostly around stocks like AMC and Gamestop.
Let’s refresh what short selling is in the most basic terms, using AMC as an example:
Borrow shares of AMC stock from your broker (Robinhood, TD Ameritrade, etc)
Sell those shares on the market (You now owe shares that you sold)
Hope to god that the market falls so you can buy them back cheaper and repay your broker
(For more analogies see our earlier tweet thread).
Basically, short selling means betting against a stock. The people who do this currently have an approval rating similar to the IRS (hint: not high). Everyone hates it because it means betting against the future, against growth, and most importantly against YOU the shareholder.
But, are we sure our hate is directed at the right parties in this instance? Someone betting against a stock you own feels bad but is it actually bad? If someone points out the leadership of the company whose stock you own is committing fraud, isn’t that something you’d like to know? We have whole government agencies trying to do this for investors, so it would make sense that short sellers can help do research and expose fraud.
Let’s look at 3 of the stocks specifically called out in the article that has been heavily shorted, and part of the DOJ investigation into short-sellers.
Luckin Coffee - Short Selling firm Muddy Waters rightfully accused them of committing accounting fraud while they raised over $800M from unknowing investors. They were fined $180M by the SEC.
Mallinckrodt Pharmaceuticals - Short selling group Citron accused them of price-fixing and other fraud, and they are now currently going through bankruptcy due to opioid-related lawsuits.
GSX Techedu - Was called a fraud by both Muddy Waters and Citron, and was part of a short squeeze led by the now-disgraced Bill Hwang of Archegos Capital. After rising following the short-seller report the fraud was confirmed and the stock is down 90%.
So, short sellers can and have spotted fraud, illegal accounting, and other violations years before government agencies. Which would actually make them beneficial to consumers, so maybe the ire of Reddit should be aimed at grifters and not short-sellers.
And sometimes this does not even have to be fraud, it can simply be a bad business model. Circling back to our AMC example, hedge funds were short AMC due to a declining business that was being hit not only with streaming platforms but also with Covid causing year-long declines in revenue. That’s not evil, that’s just logic.
When we highlighted this short squeeze earlier in the year, the stock reached all time highs:
So the Reddit apes were able to stick it to the shorts, and cause billions of dollars in losses for hedge funds. But did they actually make the right call?
Since AMC reached its peak the stock is down nearly over 50% and insiders are unloading stock including over $35M in sales from the CEO, and the CFO selling ALL OF HIS SHARES.
So in fact it's not short-sellers, we have to be concerned about its fraud, and grifters.
What’s the Upside?
We believe that short sellers play a vital role in policing the public equity markets. Not only were they early to spot fraud in many of the names the DOJ is investigating but they also may simply be right about a company's future prospects like AMC’s declining business.
While it may be unfortunate to have hedge funds short a stock you own, it may also be a red flag to look further into what they are saying. And instead of banding together will all the Redditors realize that the real enemy might be the company you own.
For Your Weekend
This is where we’ll post a round-up of essays, podcasts, and streaming shows to check out over your weekend. We cast a wide net so you don’t have to.
Read:
The Absurdity of Renting a Car Will No Longer Be Tolerated by Kaitlyn Tiffany (The Atlantic)
What do you expect will happen when you walk into a rental-car office? Do you think you’ll turn over your credit card and your driver’s license, and walk out with the keys to at least generally the type of car you’ve reserved, having agreed to at least roughly the fee that you were quoted? Or do you picture something else?
“I’m expecting chaos,” says the comedian Caleb Hearon
The Omicron Best-Case and Worst-Case Scenarios by Michael Totten
Governments, businesses, and consumers are tipping back into heightened emergency mode as the news sinks in about the Omicron wave of COVID-19 and its rapid spread. Although it is still too early to say anything definitive, there is reason to hope that Omicron may prove less dangerous than previous variants—and may even, if we’re very lucky, bring the world closer to the end of the pandemic.
Watch:
Klaus (Netflix)
A selfish postman and a reclusive toymaker form an unlikely friendship, delivering joy to a cold, dark town that desperately needs it.
A fun re-imagining of the Santa myth with a stellar voice cast (Jason Schwartzman, JK Simmons, Rashida Jones, Norm Macdonald, and more). Perfect family fare. Switch it up this Christmas season (or just watch one of the Home Alone’s).
Chuckle:
