Intriguing reading from Worth magazine on shorting:
worth.com
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Beware of Shorts
There are two schools of thought on the subject of shorting, or selling borrowed shares of stock. The traditional view holds that a large amount of short selling is positive for a stock because it represents future demand.
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Short interest indicates negative information about a stock.
But the dissenting opinion, supported by a recent Harvard Business School study called "An Empirical Investigation of Short Interest," by Paul Asquith and Lisa Muelbroek, shows that short interest (which is measured as a percentage of shares outstanding) actually indicates negative information about a stock that has not been digested by the market.
High short interest is associated with lower dividends, higher betas, and higher variances.
Examining companies on the New York Stock Exchange and American Stock Exchange, Asquith and Muelbroek found that average short interest increased from 0.23 percent to 1.78 percent, or almost 800 percent, between 1976 and 1993 while the median rose by more than 13 times.
The large majority of stocks had no short interest at all. And most of the stocks that did have short interest had only a small amount. For example, in 1990 the median level of interest for shorted stocks was only 0.5 percent while roughly 1 percent of firms had short interest in excess of 14 percent. Not surprisingly, the authors find that high short interest is associated most with smaller firms with lower dividends, higher betas, and higher variances.
Short interest is closely associated with excess negative returns.
Focusing on the most heavily shorted firms, the professors found compelling evidence for the case that short interest is closely associated with excess negative returns: Companies with short interest of 10 percent or more declined 16.1 percent more than the market while heavily shorted, and 22.1 percent more in the following two years. Companies that had short interest of at least 2.5 percent returned 16.3 percent worse than the market while they were heavily shorted and an additional -17.1 percent over the net two years. A portfolio composed of this latter group of stocks would have underperformed the market between 1976 and 1993 by more than 144 percent.
The study has some very clear implications for investors: 1) prices adjust more slowly to negative information; 2) shorting a diversified portfolio of heavily shorted stocks can lead to superior returns; 3) an already-owned stock that develops a significant level of short interest should be sold.
Post your questions and comments about shorting stocks for columnist Jonathan Butler on the "Studying the Street" message board in the "Let's Talk Stocks" folder.
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