In today’s W$J, Holman Jenkins stands up for short-sellers, and rightly so. Those folks have taken a bit of a beating lately. They’ve been sued by companies like Biovail and Overstock.com and trashed on talk shows like CBS’s 60 Minutes.
[NOTE: I originally linked to the 60 Minutes segment, but I just realized that the segment includes a warning that unauthorized Internet display is prohibited. The segment is available on Overstock’s website here. Just scroll down to the event on March 26, 2006 — “Biovail Story on CBS’s 60 Minutes.”]
Attacks on short-sellers are nothing new. Those investors — who borrow the stock of companies they believe is overvalued, sell it, and then repurchase it (hopefully at a lower price) before the date by which it must be returned — make their money by betting against companies. This, many believe, is evil. Indeed, Malaysian law deemed short-selling to be grounds for caning (yes, getting smacked with a cane) until just two weeks ago!
Those who reflexively jump on short-sellers for, as Jenkins puts it, “push[ing] down stocks owned by widows, orphans, and other helpless shareholders” assume that higher stock prices must always be better for investors than lower ones. Tell that to the folks who bought Enron at $90/share. They certainly wish there had been more shorting of Enron stock.
In addition to the “investor reliance” losses occasioned by overvaluation, such mispricing can lead to destruction of significant corporate value. Harvard Business School Professor Michael Jensen has recently explained why this is so in his fantastic paper Agency Costs of Overvalued Equity. Jensen shows that a higher stock price is not always better for investors. Indeed, a high but unjustified price can be downright bad for holders of a stock.
Short-sellers play a crucial role in sniffing out those stocks that are priced higher than they ought to be and helping to bring their prices down. In theory, corporate managers and professional stock analysts would take steps to correct overvaluation, but there are good reasons to believe that neither group is up to the task. (For why this is so, see below the fold.)
First consider managers — the people closest to a firm’s business and thus best able to correct overvaluation. Whereas those folks will almost almost always take steps to correct a stock price that’s lower than fundamental value, they’re slow to take steps to correct overvaluation. First, as Professor Donald Langevoort has argued (see here), managers may be subject to biases that lead them to be falsely optimistic about their firms’ prospects. In addition, they are more likely to be aware of “good news” than “bad news,” for underlings are more likely to pass along the former (which makes them look good) than the latter (which makes them look bad). Moreover, even when managers are fully rational (i.e., not falsely optimistic) and fully informed, there’s little they can do to correct overvaluation. They can fix underpricing by going to the market with price-enhancing news and analysis or by causing the firm to repurchase its own stock (thereby signaling confidence that the stock is underpriced), but they generally can’t go “talk down” their stock price or signal overvaluation by selling firm stock. If they talk down the price, they’ll get fired; if they cause the firm to sell stock, they may just signal the market that the firm is seeking money for expansion. Managers, then, are unlikely to correct stock overvaluation.
Same goes for professional stock analysts, who have, in recent years, issued nearly 100 times as many “buy” recommendations (public predictions that a stock is undervalued) as “sell” recommendations (public predictions that a stock is overvalued). Despite an apparent interest in forecast accuracy, analysts frequently turn a blind eye to bad news. Consider Enron: Even after the SEC had begun investigating the firm, the CFO had resigned, and the Wall Street Journal had run a series of articles on Enron’s suspicious accounting, 15 of 17 top Wall Street analysts interviewed by the Journal maintained buy recommendations on Enron stock. Why such optimism? Because stock analysts are typically employed by institutions that make most of their money providing investment banking services for companies whose stock is being covered and who don’t want to see “sell” recommendations. (For more information on analysts’ incentives, see here.) Now, one might conclude that the market will see through these rosy analyst reports, but the fact remains that analysts cannot be counted on to provide price-decreasing information to the market.
So the two groups of people in the best position to correct stock over-pricing — a phenomenon that can create huge losses for investors — are unlikely to do so. Perhaps that’s why, in Jenkins’ words, “a surprising and dangerous consensus has been emerging among economists that short selling can and does make an important difference because stock prices may otherwise be biased to the upside” (emphasis added).
To the extent short-sellers reduce the incidence and magnitude of overvalued equity, and the value destruction it occasions, they may be among investors’ best friends.
For more on this topic, see Larry Ribstein’s excellent recent posts here and here. For a more general discussion of why overvaluation is more likely to occur and persist than undervaluation, see my recently posted working paper, Overvalued Equity and the Case for an Asymmetric Insider Trading Regime.