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Why Investors Short Sell Stocks and How You Should React

Posted on October 10th, 2013. Posted by

“Why is there so much short interest in my stock?” Many executives find themselves asking this question, especially when it seems things are going well. Stocks have been “shorted” for many years now, but there is no doubt that the practice has seen much wider use – and brought about more management frustration – in recent years. Doesn’t short selling expose funds to unlimited losses? Why do investors take the risk?

Much like with negative analysts, the most tempting answer – and biggest misconception – is to believe it is personal. It might be true that your short investors don’t like you. But that is not the reason they put in that short order.

Why do investors short stocks?

  • For the same reason they buy – to make a profit. With greater liberty to sell short, many modern investors no longer just try to “buy low and sell high.” Instead, they may also “short high and cover low.” Betting on valuation is what portfolio managers are in the business of doing, and if they want to take the bet that a stock’s price will be lower in the future than it is today (and are now allowed and able to do so), then shorting, obviously, is one way to do that.
  • When they want to bet on the outcome of an event.  The borrowing costs associated with selling short often encourage investors to mainly utilize the practice for the short term – especially around near-term catalysts. If important clinical trial results are looming or if there is a subject of high uncertainty or risk (e.g. a court hearing or competitor data) that may rear its head soon, market forces may invariably attract some investors to take the short view on your name, especially if the stock has performed well thus far.
  • Hedging. The hedge fund is often viewed today (and perhaps rightly so) as a high-risk investment vehicle. But once upon a time, there was a hedge fund business model that used short selling as a way of mitigating portfolio risk. How? The basic idea is to short a basket of stocks that simply reflect the market, reducing exposure to overall market fluctuations and volatility. Today, some funds even have mandates to maintain specific levels of short exposure for this very purpose. If your stock is in an index it is likely that some of the short interest is related to this phenomenon.
  • Cover/shrink a long position. Though much less common, short interest is sometimes not due to investors betting against your stock but rather to long investors protecting some gains. For one reason or another (e.g., reporting or tax benefits), a portfolio manager may prefer to short the stock for a time instead of simply selling outright. Your short interest on paper might look worse, but in reality you may not be dealing with any new shorts at all.

“But, isn’t there anything I can do about all this short interest?” Of course there is. And your approach should not differ that much from the way you deal with negative analysts:

  • Be transparent. Disclosure is always the most powerful weapon against shorts. Even if the shorts are right about some new headwind or setback, you’re usually better off in the long run letting the cat out of the bag and allowing your stock to recalibrate sooner rather than later. Specifically, this could mean it is wise to pre-announce results or provide a mid-quarter update on guidance. Time can be on your side to re-build your positive momentum if you set the record straight now.
  • Avoid the cold shoulder. Completely ‘shutting out’ people you suspect might be shorting your stock is a terrible investor relations strategy. Hiding, or even making it look like you’re hiding, can often add fuel to the fire. Instead, engage and take an interest in the views and questions of short sellers, without getting defensive or evasive. This is a powerful practice – and can potentially turn that short investor into a long-term advocate for you in future circumstances.
  • Don’t get defensive, and especially don’t lie. This is all too common. Investors, especially those who sell short regularly, tend to be highly sensitive to people’s ‘bluffing’ cues. The last thing you need is for your stock not only to have potential business overhangs (probably the original reason investors started shorting) but also management credibility overhangs.
  • Execute. It’s cliché, but it’s the truth. Results speak for themselves. If the shorts or critics you’ve sat down with are simply wrong about your prospects and refuse to accept your explanations or clarifications, you will ultimately always have a chance to show your hand when the results come out. Keep working hard on producing those results, and short investors will have little choice but to find something more profitable to do.

Shorting stock is not uncommon in today’s market. Don’t take it personally, and don’t let it rattle you. Instead, use it as an incentive to build an even stronger case (and plan) for your company. If you need help coming up with an effective game plan and talking through your options, Westwicke can help. Contact us to start the conversation.

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ICR Westwicke is the largest healthcare focused investor relations firm in the country. We provide customized investor relations programs and independent capital markets advice to small and mid-cap healthcare companies.

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