Don't Short Me, Bro!

March 20, 2009 6:45 AM

How does short selling stocks harm the underlying company? To my way of thinking, it shouldn't.

But Samantha Bee on the Daily Show seems to think it does. Earlier this week she did a piece about the short sellers and made them out to be among the bad guys in the current financial storm.

But I don't see how this hurts the companies that the stocks are in. Unless those companies are somehow leveraged to their own stock, which seems like a not so good idea regardless of what happens.

A hypothetical, as I understand it: XYZ Corp. decides to go public. They sell a bunch of shares in the company. They take the cash, and give up slices of ownership. Once the original purchaser buys that stock, that original purchaser can do with it what they please. It's out of the hands of XYZ Corp. Now, I decide XYZ Corp.'s stock is going to go down, and I want to make money off of that. Say it's at $20. I find someone holding stock who is willing to let me borrow it for a while. I borrow that stock and sell it at $20. Now, time comes that I need to give the stock back to who I borrowed it from. Lucky for me, the stock is down to $10, so I buy the stock back and return it. And I've doubled my money. But XYZ Corp. isn't involved in that process. The only loser in this scenario is the clown who decided to sell their stock at $10. And they are only losers if they bought the stock for more than $10. If they bought it for $5, there are no losers in that scenario.

What am I missing? Or, is she wrong?

(Obviously, this assumes the people doing the short selling aren't engaging in market manipulations. They are doing it on the up and up, within the rules.)

posted by gjc to work & money (28 answers total)

It's not the short selling per se, it's the fomenting that goes along with it.

Also when people see a lot of short selling going on in a certain company, they assume something is going to happen and join in, then guess what? The company's stock dives.
posted by Pollomacho at 6:53 AM on March 20, 2009

I think the idea is that those who are shorting the stock go out and try to spread rumors that will drive down the stock price. It's bad for company XYZ if the company's value is artificially lowered because there are high-profile traders talking about how the stock is certain to tank, just to influence people to sell. That's not to say it happens all the time, though. (On preview, what Pollomacho said)

As a very small micro-level example, the only stock I really follow is iRobot Corp (IRBT). Their Yahoo forums are full of people come in and insisting that doom is upon us every time the price drops at all. They're wrong about 50% of the time (as I think everyone is when trading stocks), but they think they're doing themselves a favor by telling the small audience of those forums that they should sell and get out of it. (Here's an example by one forum member who took it upon himself to do a post like this nearly every day. Even when the stock would go up steadily over the course of a week or two, he'd be insisting it would tank immediately.) On this small scale it's not as effective as it may be if someone important is saying the same sorts of things, but it shows the "strategy".
posted by olinerd at 6:56 AM on March 20, 2009

I know someone more knowledgeable will come along, and answer this fully, but you're right, it shouldn't harm the company when done right.

But a short sale is bet that the company stock will go down. If enough money is piled into these sales it is essentially a vote the company is bad.

Where would you want to put your money? In a company that everyone thinks is great and is making money, or one where the majority is banking on it failing?

These short sales can be used to be self fulfilling prophesies, with enough money (like one of the big retirement funds), I can beat a company down until I create the very thing I am betting will happen.
posted by cjorgensen at 6:57 AM on March 20, 2009

I think some of it may just have to do with perception. Markets are, to some degree, based on group thinking and group action. So, say there's a report on the news that Company X is doing really well - okay, the stock goes up because people think Company X is a really great stock and therefore the stock should be worth more. But Company X didn't do anything to make the stock go up. And before the report, it's not like a bunch of people were buying stock of Company X and driving the price up. It's simply that Company X is being perceived as a strong buy, so the price goes up.

Same thing with short selling. If a large enough group of people start shorting Company Y, people are going to notice. And they're going to say, "hey, why do all these people think Company Y sucks?" And that has the potential to drive the price of Company Y down.
posted by billysumday at 6:59 AM on March 20, 2009

After reading the original question, I was left wondering the same thing--how does this hurt the company? I get the "short selling leads to lower stock price" mechanism that has been explained so far. But them I am left wondering how does a lower stock price hurt the company, since they've already sold their stock off at $20.

Is it that it discourages other types of investment in the company? Discourages potential customers from buying from a company that looks like it's going out of business? Or is there some mechanism of direct monetary loss when their stock price falls?

And is it poor etiquette to post a question instead of an answer in somebody else's AskMeFi post? If so then I apologize...
posted by FishBike at 7:06 AM on March 20, 2009

one must distinguish micro examples with macro forces

when the sec banned nake shorts in the wake of lehman, there was very little amelioration (some argued a measurable erosion) in market direction, as naked shorts do offer some modicum of liquidity when not rampant.

However ETFs change this equation dramatically, as their market cap becomes a driving force in speculation and increases volatility dramatically.

example gratis - SKF's effect upon DJUSFN.
posted by stratastar at 7:06 AM on March 20, 2009

I'm not an expert, but my understanding that regular short selling is not so bad. *Naked* sort selling is the big problem. This is where you don't actually borrow the stock before you sell it. Don't ask me how, but people actually did this.
posted by originalname37 at 7:15 AM on March 20, 2009

Not sure if it will help, but here's an analogy: Let's say you buy great comic books, not because you want to read them but because you think they will be worth more down the line (not a good idea, but it's just an analogy). Then let's say some guy asks if he can borrow your comic book from you, to later give you back a brand new one in the same condition. You're not actually using it, so you agree.

That guy then takes the comic book back to the store and gets a refund. Normally this wouldn't be a big deal, but tons of guys like him are doing the same thing. Almost half of the comic books that have been sold have been borrowed and returned to the stores. The store owners are puzzled, and everyone assumes that the comic books must suck if they are getting returned so often. The producer of the comic book cancels it, and the comic book store throws all of the unsold copies into the bargain bin. The guys who returned the borrowed comic books buy the discounted ones, keep the leftover refund money, and give the comic book back to the original owner.

The big question in this scenario why the original owner would agree to lend out his comic book. He doesn't get anything out of the deal, and it directly results in his investment being degraded. The same question is valid in real short selling, and the answer is that nobody actually agrees to let someone borrow their stock, it happens automatically in order to make all stock transactions easier. Many people think that a lot of the problems inherent with short selling would be solved by going back to requiring people to actually arrange to borrow stock to sell short rather than the current system.
posted by burnmp3s at 7:24 AM on March 20, 2009 [3 favorites]

A lower stock price can make it harder for the company to issue shares to raise capital, because they need to dilute existing shareholders by a larger amount to raise the same amount of money - but that's about it really.

And it doesn't stop them from issuing bonds or selling preferred shares to raise that capital.

The whole "short selling is bad" meme is a bit of a beatup really.
posted by The Shiny Thing at 7:35 AM on March 20, 2009

I don't think it's a given that a falling stock price is the direct result of short sellers, but...a plummeting stock price usually means that the company in question would have a more difficult time raising additional equity capital on short notice. The rating agencies view "access to the capital markets" as a key factor in their assessments. Rating agency downgrades have a number of immediate negative consequences, such as collateral calls and reduced access to short-term debt. This was a big problem for many on the financial companies that have fallen apart in the current crisis.

But I am of the the opinion that it's bullshit to demonize short sellers. Many are doing the market a great service (Jim Chanos' efforts uncovering Enron, David Einhorn investigating Allied Capital and Lehman, Bill Ackman investigating MBIA, etc). Most are doing nothing different than what legions of investors and the financial media do on behalf of long investments. And, of course, there's a hedging aspect that also gets lost in the shouting match.

Naked short selling is an issue, but I think in most cases it is the broker's fault, not the short seller. And the recent "ban" isn't really new, it was just an strengthening of enforcement.

the answer is that nobody actually agrees to let someone borrow their stock, it happens automatically in order to make all stock transactions easier.

I suppose it's true that the retail-level investor doesn't know about it, but the institutions that administer the funds have securities lending programs that earn fees for making stocks available to borrow.
posted by mullacc at 7:44 AM on March 20, 2009 [1 favorite]

burnmp3s- I like the answer. Excellent point about the automatic nature of the borrowing process. And your analogy is apt in the short term. But if I'm a long term owner, doesn't it settle out? In your comic book example, it might even be beneficial- buyers of the bargain bin books might throw their copies away, actually increasing my long term value.

In a stock, if I'm holding it for the long term, I'm betting on the long term performance of the company/stock. So the ebbs and flows of day to day rumors don't hurt me. I believe that in X years, the stock price will appreciate. I can even buy more shares of the stock when its price drops, believing I'm getting a bargain.

I'm thinking of that thing that happened last year, where some newspaper accidentally published an old story saying UAL was headed for bankruptcy. Traders sold the stock down to nothing, while investors bought the stock believing there was some kind of value to be had. The stock price rebounded relatively quickly. This leads me to wonder if the emotional groupthink of the market is only detrimental to other lemmings.
posted by gjc at 7:50 AM on March 20, 2009

If I understand correctly, the foundation of your question is "How does the stock price, or fluctuations to the stock price, or factors that affect the stock price (ie: short selling) affect the company after the stock is initially sold". I have always had this question, and I could never find an adequate answer.
posted by Simon Barclay at 8:27 AM on March 20, 2009

Short sales only hurt shaky companies that are dependent on their stock prices -- solid companies with good fundamentals aren't bothered by them at all. Good companies, ones actually worth owning, pay dividends or, as a trick to avoid taxes, buy back shares.

In the first version, they don't care what the stock price is, and investors will buy the stock once it gets below a certain point, because the dividend is appealing. A dividend-paying company with sound fundamentals is very resistant to stock manipulation. In the second case, they LOVE short sellers, because it means they can pull more stock off the market for the same amount of invested profit. Eventually, that will pay off for the long-side investors. It looks bad this quarter, but it'll look great next year.

The reason shorts are hated is because most modern investing is a casino, where people are trying to outguess what other people will pay for shares, instead of buying a piece of a company they understand. Short sellers drive the price down, and your chips lose, so people don't like them. And many companies are just shells that are based around their stock price, with no actual profitable business. Dotcom bubble companies were great examples. Shorts can really hurt this kind of company, but they're doing the market a FAVOR, revealing the truth.

As Buffett has said, in the short term, the stock market is a voting machine; in the long run, it's a weighing machine. Shorts don't change stock weights much, just their vote tallies.
posted by Malor at 8:58 AM on March 20, 2009 [1 favorite]

Unless those companies are somehow leveraged to their own stock, which seems like a not so good idea regardless of what happens.

but most companies are valuede by the value of their stock aren't they and hecne the value of the stock determines the maximum Debt they are 'allowed' to maintain by various bodies / banks lending institutations.
posted by mary8nne at 9:28 AM on March 20, 2009

In a stock, if I'm holding it for the long term, I'm betting on the long term performance of the company/stock. So the ebbs and flows of day to day rumors don't hurt me.

That's a good point, and as Malor said companies that are doing well are pretty much immune to the impacts of short selling. In the long run, shares sold short have to be bought back, so their effects on the share price are reversed eventually. But short selling, especially when combined with other tactics can have extra negative effects on a company that aren't adjusted back up.

For example, let's say there's a small company that makes most of its money on licensing something, like an archive of film footage. They have a bad quarter, due to making less than expected profits. A large group of people expect this trend to continue, and short the stock, while also using their influence to spread negative rumors about the company. All of this causes analysts to downgrade the company, and many people follow the trend and sell stock they have been holding as an investment. Instead of spending time making improvements to their business, the employees at the company spend a lot more time talking to analysts, sending out press releases, denying false rumors, etc. in an attempt to convince everyone that the market is undervaluing their stock. The next quarter they do even worse, partially because they shifted resources away from running the business, and the stock drops again. At this point, a big company figures out that their film archive is worth more than the total market value of the company, so they buy out the small company for a small premium above the market value, and lay off all of the people who used to work there. That's an extreme example, but stock price changes in general can have negative effects on the actual business itself that can harm the interests of long term investors.
posted by burnmp3s at 9:45 AM on March 20, 2009

Everyone's already mentioned the technical reasons.

For a little more background Jon Stewart's recent feud with Jim Cramer also brings helps make Samantha Bee's statements a bit clearer.

A huge part of Cramer's appearance on the Daily Show was around a video of Cramer talking about how he could negatively affect the stock price of Apple in order to cover a short position.
posted by bitdamaged at 9:53 AM on March 20, 2009

a plummeting stock price usually means that the company in question would have a more difficult time raising additional equity capital on short notice. The rating agencies view "access to the capital markets" as a key factor in their assessments. Rating agency downgrades have a number of immediate negative consequences, such as collateral calls and reduced access to short-term debt. This was a big problem for many on the financial companies that have fallen apart in the current crisis.

This is the nub of it, right? Sure "strong" companies aren't affected, but companies that are going through tough times (and might pull through) can be pushed over the edge by short selling and the market manipulation that the practice of short selling encourages.

Permitting short selling incentivizes company failure. In an economy like this, that's a problem.
posted by tiny crocodile at 10:05 AM on March 20, 2009

burnmp3s: [...] Instead of spending time making improvements to their business, the employees at the company spend a lot more time talking to analysts, sending out press releases, denying false rumors, etc. in an attempt to convince everyone that the market is undervaluing their stock. [...]

But why does a company care what their stock price is? (Besides the extreme ending in your example.)
posted by Simon Barclay at 10:06 AM on March 20, 2009

but most companies are valuede by the value of their stock aren't they and hecne the value of the stock determines the maximum Debt they are 'allowed' to maintain by various bodies / banks lending institutations.

This isn't true, as far as I know. Credit decisions are usually made based on the book value of equity (i.e., the equity capital contributed at cost plus retained earnings). Cash flows and collateral value also play major roles in credit decisions as well. If a company is well-capitalized, has strong cash flow and valuable assets it can lend against, the stock price shouldn't matter.

The major exception is the effect stock price has on credit ratings due to "access to the capital markets" as I mentioned in my post above. But even credit rating agencies will focus on book equity in their financial statement analysis.

A large group of people expect this trend to continue, and short the stock, while also using their influence to spread negative rumors about the company.

Why is the expectation of a negative trend a "rumor"? No one puts that sort of negative spin on investors who discuss their expectations of positive trends.

Instead of spending time making improvements to their business, the employees at the company spend a lot more time talking to analysts, sending out press releases, denying false rumors, etc. in an attempt to convince everyone that the market is undervaluing their stock. The next quarter they do even worse, partially because they shifted resources away from running the business, and the stock drops again.

Managers who let this happen are doing a disservice to investors and should be fired. To the extent short sellers reveal this sort of misbehavior, they should be applauded.

The fraudulent activity Cramer talks about is already illegal. Curtailing legitimate short selling in an effort to eliminate that sort of bad behavior is cutting off your nose to spite your face. If anything, it helps entrenched management who are looting their own companies.
posted by mullacc at 10:08 AM on March 20, 2009 [1 favorite]

Permitting short selling incentivizes company failure. In an economy like this, that's a problem.

Permitting long selling incentivizes asset bubbles. In an economy like this, that's a problem.

But, seriously, how can it be an incentive for failure? Short sellers aren't running the companies they short and can't directly contribute to firms' failures so long as they act within the law. To the extent illegal behavior exists in the market, it's a problem on both the long and short sides. Pumping and dumping a stock is just as illegal and harmful as knowingly spreading false rumors to drive down a stock.
posted by mullacc at 10:15 AM on March 20, 2009 [1 favorite]

Simon Barclay: companies care what their stock price for a number of reasons.

1 - debt that has been issued to the company is usually based on the value of the company, and that is determined by the stock price. If the value suddenly plummets the holders of that debt might call it in and then you're screwed. (Imagine that your mortgage is based on the value of your house (crazy idea, but just roll with it) and you're happily paying your mortgage every month. Then one month the bank discovers that your house is now only worth 10% of what it was worth when they loaned you the money to buy it. Even if you could still make your payments every month, the bank could be obliged (by banking regulations etc) to call in the loan and ask you to pay it off completely or else... that's how it works for a lot of debt that has been issued to companies.)

2 - executives hold stock or stock options. They are supposed to be helping to grow the company and so their compensation is often tied to the stock price. While this doesn't affect the company per se, when the entire "head" of the beast is beholden to the stock price (and a lot of the limbs and organs too - if you'll forgive the extended metaphor), it has an indirect effect on the company.

Anyway, those are just two fairly basic reasons.

G.
posted by gwpcasey at 10:35 AM on March 20, 2009

Why is the expectation of a negative trend a "rumor"? No one puts that sort of negative spin on investors who discuss their expectations of positive trends.

My wording wasn't clear, but by negative rumors I meant false information intended to generate bad press. The opposite of a pump and dump just as you described it, basically.

But, seriously, how can it be an incentive for failure? Short sellers aren't running the companies they short and can't directly contribute to firms' failures so long as they act within the law.

I agree with you in general that short selling is most likely a necessary component of the market, and that if people just use it in the way it's intended it has a positive effect of making the market valuations more accurate. I think tiny crocodile's point was that once you get a lot of people on one side of a bet, those people are going to use their resources (legal and illegal) to make sure their bet pays off. Letting people bet millions of dollars in Vegas that a team will lose the World Series increases the chance that things like the Black Sox scandal will happen. That doesn't necessarily mean that those kinds of bets should be illegal, or that making those bets illegal would actually solve the problem, but the fact that the bets exist does influence how the people involved act.
posted by burnmp3s at 10:38 AM on March 20, 2009

1 - debt that has been issued to the company is usually based on the value of the company, and that is determined by the stock price.

NO. No, it is not. Doesn't anyone read the previous answers before posting theirs?

A company is not the same a home, so the mortgage analogy does not work. If the bank forecloses on the house, they have a reasonable chance to sell the house for the value of the mortgage. The financial condition of the borrower doesn't affect the value of the asset (the house). With a company, if things get bad enough for the lender to foreclose on the assets, the stock will already be worthless and thus any underwriting done based on the market value of the assets will have been for nought. Instead, lenders focus on the book value of assets, in other words, they focus on the amount by which assets exceed liabilities (another way to say paid-in capital plus retained earnings). This is a better reflection of the liquidation value of the company. If a company's stock price has dropped 99%, but it still has $100MM of tangible net worth and wants to borrow $10MM, there will likely be a lender that will do it. However, if a company whose stock has gone up 300% in the last year, but has hugely negative net worth and no hard assets, tries to borrow $10MM, it'll have a difficult time.
posted by mullacc at 11:00 AM on March 20, 2009

However, if a company whose stock has gone up 300% in the last year, but has hugely negative net worth and no hard assets, tries to borrow $10MM, it'll have a difficult time.

Sure, in the last year, but in 2007, it was all, "are you sure you don't want an extra $10 mil for your CEO?"
posted by Pollomacho at 12:18 PM on March 20, 2009

But them I am left wondering how does a lower stock price hurt the company, since they've already sold their stock

"How does the stock price, or fluctuations to the stock price, or factors that affect the stock price (ie: short selling) affect the company after the stock is initially sold". I have always had this question, and I could never find an adequate answer.

I'm here for ya, guys. The easiest way to get your brain around this is to think about what happens when the company receives money for selling stock. They use that money to expand the value of the company, by:
- building factories
- hiring people
- investing in other companies

And they may keep a portion, but not too much, for a rainy day. They may buy some of their own stock too.

So most of that money is gone. The company will always need more funding to keep growing, and the funding can come from:
1. issuing more stock
2. selling their investments (stock in other companies)
3. issuing bonds and/or preferred stock
4. retained earnings (i.e. profits that are not paid out as dividends to the shareholders)

If the stock price is too low, then:
1. It is not cost effective to issue more stock; there's a cost associated with doing so, and if the stock price is too low, you can actually take a loss by issuing it.

2. Your investments in other companies are causing you major headaches right now. Your books have to reflect the market value of those investments, otherwise the books would not accurately reflect the value of your company. For example, if your company bought Bank of America shares at $43 a share, it would misrepresent the value of your company to keep them on the books for $43 per share when they are currently selling for $6 bucks a share. Say you decide to keep the BOA stock because you think it will rebound someday. On your books, it would be an "unrealized loss" (a paper loss) and is treated as an adjustment to stockholder's equity on your balance sheet. Unless you sell it, when it becomes a real loss and shows up on your income statement. Whatever of your own company's stock you have has to be adjusted, too.

3. Because your equity is taking a hit, your ability to pay back any loans becomes less certain. So it becomes more expensive for you to float bonds; you have to pay more interest to get people to buy them. Just as in your personal life, credit is a lot cheaper if you look like you can pay it back. And the primary buyers of preferred stock are other companies (for tax reasons), who are not buying much right now. And even if they could, they wouldn't buy yours because you will soon won't be able to pay dividends because of #4.

4. Okay, so say retained earnings from last year are good. You took that money from the stock you sold and made all the right decisions on what to do with it. You had a great year last year, sold lots of stuff, and made tons of money which you kept as retained earnings. You still have a problem. You have to use your retained earnings to pay for continuing operations because you can't get credit because of reasons 1, 2, and 3. And people are buying less stuff this year because they're afraid of being laid off, so your earnings suffer, and so you start laying people off to try and cut costs...

On preview, this is similar to what Mullac said only with a lot more words (I agree with him on selling short, too). But I hope you find it helpful.
posted by txvtchick at 12:20 PM on March 20, 2009 [1 favorite]

why does a company care what their stock price is?

The share price has a direct influence on the market cap of a company. The market cap is calculated by multiplying the number of shares outstanding by the share price. The market cap is the public's perception of the value of the company and is used for many things, including: how a company is categorised (small cap, large cap etc) as well as the issue of Indices. Many market indexes, such as the S & P 500 or the FTSE 100 are weighted by market cap. So the FTSE 100 is the UK's 100 largest companies by market cap. It is re-evaluated quarterly and if a company's market cap falls, the company falls out of the FTSE 100.

Book value, as mullacc mentions above, is an accounting term and is basically a company's tangible assets minus its liabilities. As far as I know, this value is not affected by the company's stock price. The book value and market cap will usually be different but both are used for different purposes.

And for those who are interested, here's an article which outlines the benefits of short-selling.
posted by triggerfinger at 12:27 PM on March 20, 2009

Some good information here already answering the question, but another interesting nuance is that some companies/industries are more exposed to the negative perception affects of short selling than others.

For example, banks and investment banks are very exposed. They are in a business of confidence; they require frequent interactions with the capital markets; and sophisticated financial counterparties and/or depositors are all taking credit risk in the long term survival. Thus, the negative perception effects of a short-selling attack might serve to become a self-fulfilling prophecy where loss of confidence and reputation can easily lead to runs of the banks, higher costs and less available sources of liquidity and funding, and an overall severe loss of business.

As an opposing example, something like a candy manufacturer might not be exposed. It might have no or infrequent interactions with capital markets; it might be flush with cash and require only very modest amounts of supplies for vendors; its main customers, children, would be largely ignorant of what is happening in financial news; and, its products require no warranty or ongoing customer/technical support services. Therefore, even an extended artificial fall in stock price might have little to no effect on the underlying business other than frustrating management's bonus desires. Inevitably, over time, a misguided attack by short sellers would be thwarted by the actual quarterly earnings generated by the business.
posted by jameslavelle3 at 2:18 PM on March 20, 2009 [1 favorite]

Thanks for the answers! Just to clarify, I wasn't talking about the market manipulations, I get how manipulating a market works and is bad. Just wondering about the short sell. And I got my answer- diddly squat. (Since the stock was going down anyway, or it wouldn't be a short sell.)
posted by gjc at 6:18 PM on March 21, 2009