Naked short-selling has always driven the conspiracy theorists nuts, and after the financial crash the Securities and Exchange Commission slapped strict new limits on the practice of selling shares you don’t, er, actually possess.
A new academic study suggests the SEC crackdown may have been misguided. While naked short-selling has the potential for abuse, especially when it is used to manipulate the price of small and thinly-traded companies, the study suggests on average, naked shorts were reacting to fundamental signs of financial weakness.
The study found a highly statistically significant relationship between naked shorting and financial performance, with short-sellers taking smaller positions in companies that were financially strong. A strategy of buying the 20% of stocks with the highest naked and covered short interest and shorting the 20% with the lowest short interest would have exceeded market returns by 15.2% a year.The paper, by Harrison Liu of the University of Texas at San Antonio and Sean McGuire and Edward Swanson of Texas A&M, looked at 2,700 firms from 2005 to 2008. The researchers examined company financial performance and compared that to the level of naked shorting as indicated by high concentrations of delivery failures, where sellers can’t come up with the actual shares they have sold.
Naked shorts bother many investors and have drawn the attention of plaintiff lawyers because they are essentially selling shares that don’t exist and thus can artificially magnify the selling volume against a vulnerable stock. The SEC tightenedRegulation SHO governing short sales in 2009 by adding Rule 204, which requires sellers to deliver shares by one day after the settlement date, typically four days after a sale, instead of the previous 13 days.
That put a serious crimp in naked short-selling, said study author Edward Swanson. Naked short interest, which hit a high of more than 0.08% of shares outstanding in mid-2008, plunged to less than 0.02% after the rule went into effect.
To assess whether naked shorts were truly targeting companies with vulnerable financials, the authors looked at indicators including profitability and leverage, operating efficiency, capital expenditures and sales growth. High sales growth is vulnerable to manipulation, the authors noted, while high capital expenditures can be a sign the company is betting on projects with uncertain future returns.
Portfolios based on covered short interest alone didn’t perform nearly as well, showing an above-market return of only 2.1% a year.
Swanson acknowledged such academic studies have a difficult time becoming successful investment strategies.
“We’re looking at this not as a money-making strategy, but as a way to measure materiality,” he said. The study, combined with earlier research showing short interest is a much more reliable indicator than positive analyst reports, suggests investors should add short interest to their checklist before buying any stocks.
“If the analyst recommendations are highly positive, I get a little reluctant to buy the stock,” said Swanson. “And if the short position is high, I’m not going to touch that stock.”
Swanson said there are certainly instances of abusive naked shorting, where speculators target a company regardless of fundamental weakness. But he said the researchers assembled a number of subsets of data and couldn’t find a single one where naked shorting wasn’t, on average, associated with the fundamentals.
The paper is scheduled to be presented at the August meeting of the American Accounting Association in California.
Original Article at: Forbes.com
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