The popularity -- and effectiveness -- of activist short-selling has been mounting on Wall Street, with some firms beginning to base their investment strategies around finding ways to spark market selloffs through bearish presentations on their targeted companies.
But investors should be wary, as the bears are not always right in their dismal outlooks, and many should learn to tune out a rising tide of PowerPoint presentations from celebrated fund managers who seem to have a knack for prompting market flight.
Short-selling is a long-established Wall Street tradition and has for decades been one of the most controversial, celebrated and reviled investment strategies. For instance, while some blamed the Crash of '29 and subsequent Depression on short-sellers, others, such as Joseph Kennedy, were able use the tactic to create new American dynasties.
In the case of the Depression, short-selling may have engendered the ire of Congress -- with Rep. Adolph Sabath of Illinois demanding outright prohibition and calling short-selling "the greatest evil that has been permitted or sanctioned by the government that I know" -- regulation has done little to mitigate public outrage or deter investors from making fortunes on short-selling, according to a Cornell Law School study that considers the role of short-selling on the October 1987 market crash.
Former Lehman Brothers CEO Dick Fuld also blamed short-selling for bringing down his firm in 2008, and thus ushering in the financial crisis, as he maintains his company did not have a liquidity crisis that justified the flight of the bears.
And most recently, despite new regulations targeting certain forms of short-selling in Dodd Frank, activist short-sellers continue to crop up in the form of celebrity market prognosticators with a decisive handle on moving the market.
Most recently, Carson Block of Muddy Waters Capital helped drive Bank of the Ozarks (OZRK) shares down as much as 8% immediately after presenting his bearish take on the company at the Sohn Investment Conference earlier this month, as Real Money reported.
Also this month, Kerrisdale Capital attempted to lure Wall Street attention by announcing it had taken a $100 million short position in an unnamed company, which it revealed to be DISH Network (DISH) in a report that detailed the bearish outlook on DISH, as well as a disclaimer that Kerrisdale held short positions.
Kerrisdale has developed a reputation for rolling out short positions in such a way, contributing to the disappearance of roughly 75% of Straight Path Communications (STRP) last fall, which appears to have been an overreaction among sellers, as shares have nearly quadrupled since their November lows.
Many skeptics of short-selling, which at times have included the Securities and Exchange Commission, have voiced concerns over the growing trend, including risks of a so-called "short and distort" scheme.
"A number of commenters have expressed concern about 'short and distort' campaigns and the incentive short positions create to spread unverified and possibly false bad news about a company," the SEC wrote in a 2014 report on regulations tied to short-selling. "In 'short and distort' strategies, manipulators first short a stock and then engage in a campaign to spread unverified bad news about the stock with the objective of panicking other investors into selling their stock."
Some of the biggest activist short flops include Bill Ackman's 2012 presentation that his hedge fund, Pershing Square, was short nutrition-products distributor Herbalife (HLF). And whle Ackman's presentation -- which equated Herbalife's business to a pyramid scheme -- helped pull down share prices by more than 40%, they quickly surged back up 200% in just over a year after.
"The Herbalife case study demonstrates the powerful sway active short sellers hold over share prices in the stock market," according to a 2013 issue of the Boston University Review of Banking & Financial Law, which argues that the quick profits of the short seller vs. damage inflicted to the market cap of the targeted corporation could lead to tightened regulation surrounding such activist tactics, which some have characterized as market maniupluation.
"When viewing the potential multi-million dollar profits available to short selling investors juxtaposed against the devastating damage posed to targeted companies in terms of reputation, falling stock prices, and cost of damage control, events like these have led to calls for some sort of regulation of short sellers," according to the study.
Such a grasp do short-sellers have on the market that their abandonment of short positions also appears to prompt a similar bull charge, if however fleeting. For instance, when Real Money reported that Andrew Left had reversed tack on his short position on Valeant Pharmaceuticals (VRX) earlier this month, shares jumped 7% before quickly falling 8%, back in line with their downward trajectory.
In short, investors should learn to be cautious when the activist bears offer a peek into their portfolios.