The Investor Who Publishes Why the Stock Should Fall

The Practice

a activist short seller establishes a short position conducts extensive research on a company and then publishes a report alleging accounting irregularities fraud or material overvaluation

If the market accepts the analysis the stock price falls and the position becomes profitable

The publication is not coincidental. Ordinary short selling waits for the market to come to the same conclusion. Activist short selling accelerates it by providing the argument

That difference is the entire business model. Holding a short position costs money and the loss is theoretically unlimited so time works against the holder in a way that it doesn't for someone who owns stock. The post turns an open hold into an event with a date which is the only way the economics of the position work

Why Nobody Else Does This Work

The strongest argument in favor of this practice concerns who else could perform the function

Sell-side analysts covering a company face structural pressure toward positive ratings as negative research damages relationships with issuers and with the investment banking side of the company

Index funds hold everything that is in the index and have no research incentive

Auditors examine what the company gives and pays them

Regulators have limited resources and generally act on complaints rather than proactively pursuing them

That leaves a gap and the only party with a direct financial incentive to spend six months determining whether a company's assets exist is someone who will benefit if they don't exist

The Record

The practice has produced genuine results. Activists' brief reports preceded the collapse of companies that were later found to have committed fraud including cases involving false income non-existent assets and misrepresented technology

In several cases the report predated regulatory action by a considerable period and the final findings on enforcement were substantially consistent with the published analysis

The mechanism that produced those results is not at all attractive: physical verification. Counting vehicles at a facility visiting sites that are supposedly operating obtaining local regulatory filings that contradict consolidated accounts and interviewing former employees

That work is expensive and is done because a position pays for it

Why the Position Has to Come First

Sequencing is the most criticized feature of the practice and also the least avoidable which is worth understanding before treating it as a scandal

Research is really expensive. Months of analyst time travel translators local file retrieval and private investigators cost real money and nothing in the exercise guarantees finding something. Something has to fund it

The obvious alternative arrangements don't work. Publishing without a position means doing the work for nothing while other people trade it. Taking the position after publishing means buying a price that has already moved so there is no return to fund the next research. Selling the research to subscribers before publishing it simply shifts the same conflict to subscribers

So the model is what it is. The researcher is paid by the market's reaction to his own statement which means that the incentive to find real problems and the incentive to exaggerate them are present in the same person at the same time

The honest way to argue this is that the conflict is structural rather than incidental it is revealed and it does not determine whether a particular report is accurate. The evidence in the report decides that and the position tells you what to check first

The Conflicts

The objections are equally substantial

Position precedes publication. The researcher establishes the brief first meaning that the report is issued by someone who benefits from the reaction to it

Selective presentation. A report is a promotional document. It presents the evidence that supports the thesis there being no obligation to present the opposite case

Position closure. A short seller can close the position immediately after the release capturing the initial move regardless of whether the analysis proves correct over time

Orientation error. A strong company report hurts a legitimate company and its shareholders and the researcher has usually already benefited from the initial decline

Most published reports include disclosure that the author maintains a short position and can trade at any time which is the transparency on which the practice is based and which limits complaints about the conflict itself

What Can Go Wrong Even When the Analysis Is Right

Being right about a company is not enough because the position can be destroyed before the market agrees

The shares must be borrowed to be sold short and the lender can take them back. A withdrawal forces the position to be closed at the price that prevails that day and withdrawals become more likely precisely when a stock is heavily shorted and contested that is when the thesis is working

Borrowing costs work against the position for the same reason. A stock that is difficult to borrow charges a higher fee so the cost of holding it increases as more people come to the same conclusion

Then there is the possibility that the price could rise sharply for reasons unrelated to fundamentals. A short position that has moved against you requires more collateral and a fund facing that demand may have to close at a loss regardless of what you believe about the company. The analysis may be fully vindicated a year later by someone else

The asymmetry underlying all of this is worth clearly pointing out because it explains the aggressive tone of the reports. The most a short can earn is the price it was sold for and there is no corresponding limit to what it can lose. Time and cost work against each other. This is a structure that rewards being right quickly and punishes being right slowly and determines both how the research is presented and what is found

What Happens in the First Hour

The post itself is a piece of market mechanics and understanding it explains several of the criticisms above better than any argument as to why

Reports are published at a chosen time usually while the market is open and are announced in advance to attract attention. The initial movement is large and fast because the people who trade in the first few minutes have not read the document. They are reacting to the existence of the document the identity of the company publishing it and what everyone else seems to be doing

Exchanges may suspend stock trading while the company prepares a response which focuses the reaction on reopening rather than slowing it down

The consequence is that the biggest move usually occurs before anyone has evaluated the evidence and the analysis that took six months is being valued by a market that has had six minutes. That is the result that the researcher can capture with certainty and everything after that depends on whether the argument holds up

That is precisely why the critique of closure has force. A researcher who covers that first step is paid to produce a reaction rather than to be right and the two things are separable in a way that is uncomfortable for the practice. This is also why the reports that most damage the credibility of the practice are those that follow silence. A company that continues to publish follow-up evidence commits to the company's refutation and continues to maintain the position months later is making a claim about the analysis. One who says nothing else has made a claim aboutthe first hour

The Legal Position

Posting opinions and analysis is protected speech and short selling is legal. The limit is market manipulation which requires deception rather than disagreement

Law enforcement has focused on specific conduct rather than practice posting statements known to be false coordinating with others to establish positions ahead of a report in an undisclosed group and the pattern is sometimes described as short and distorted meaning fabricating negative claims to benefit from a decline

Several jurisdictions have investigated activist short sellers and the results have varied. The distinction that courts and regulators make is between an aggressive argument that turns out to be wrong which is not actionable and a claim that the author knew was false which is

Exposure is not evenly distributed geographically. A researcher publishing about a company in a jurisdiction with strong opinion protections faces a different risk than one publishing about a company whose home jurisdiction treats criticism as an attack on a national champion and companies have retreated from covering entire markets for that reason. The result is that coverage is lower where disclosure standards are weaker which is the opposite of where it would be most useful

The Corporate Response

Target companies respond in recognizable ways and the response is itself informative

A rebuttal that addresses the specific factual allegations point by point with documentation is what an innocent company can present

A response that emphasizes the short seller's motives announces a buyback or threatens litigation without addressing the substance is what produces a company without a response

Litigation against short sellers has a poor track record when the underlying allegations were accurate and its primary effect is often to extend the period during which the allegations remain in the news

The response that carries the most weight is one that the company cannot fake which is a change in what it discloses. Producing the specific document commissioning an independent investigation with a mandate to publish it or having the auditor address the point directly costs something and creates a record. An announcement that the board has full confidence in management costs and generates nothing making it the most common response and the least informative

How to Read a Report

The useful discipline for anyone who owns stocks is to separate categories of claims

Verifiable Factual Claims such as filings in another jurisdiction that contradict reported figures or a facility that does not exist can be verified and are what matters

Valuation arguments They are opinions and are worth exactly what the reasoning supports

Management characterizations They are often the most rhetorically effective and least evidentiarily useful part of a report

The Questions That Sort the Good Reports From the Rest

Beyond categorizing claims some tests separate research from drama and can be applied without any specialized knowledge

Does the report show its sources?Reproduced presentations dated photographs accompanying documents in original language with translation.A claim based on anonymous industry contacts cannot be verified and should be weighted accordingly

Do you participate in the strongest counterargument? The company has an explanation for what is alleged and a report that anticipates and addresses it is doing analysis while one that ignores it is doing promotion

Is the thesis falsifiable and on what time scale? A specific claim that there is no subsidiary is resolved. A claim that accounting is aggressive and excessive valuation can be maintained indefinitely no matter what

And what is the investigator's own track record including reports that didn't work? A firm that has been wrong publicly and acknowledged it is more credible than one whose website lists only successes which is survival applied to a history of accusations

The Bottom Line

The short-selling activist funds investigative work that no other market participant has reason to do and has repeatedly identified fraud before auditors and regulators. It is carried out by parties who established their position before publication and who benefit from the reaction which is disclosed and does not undermine the analysis. The correct response to a report is to check the verifiable factual claims and see if the company responds to them because a company that cannot address specific allegations point by point is telling you something that the report could not