If you own any shares in a company that complains that short sellers have targeted it, sell the stock.

By Daniel | June 28, 2007

Large, experienced short sellers do indeed target certain companies. First, some sophisticated short sellers identify a company whose stock they believe is overvalued. They then proceed to accumulate their own short positions. Once they have established a sufficiently large short position, they bad-mouth the targeted company to the press in hopes of helping its stock price fall. Ideally, they would like to cause the price to collapse. The sooner they can help the market see the stock’s weakness, the quicker they can realize their profits and move on. Usually when short sellers target a company, they have what they think are good reasons for believing that its stock is overpriced. They have a story to tell or, should we say, a story to sell. Their analysis of the underlying values may not be correct, just as any other investors/analysts may or may not be correct in their own assessment.

If the short sellers’ analyses are incorrect, the company whose stock they sold short will perform better (profits, sales, growth) than the short sellers expect. This favorable performance is likely to result in the stock price rising rather than falling. That often happens to short sellers, just like many times investors buy (take a long position in) a stock that goes down. On the other hand, the short sellers’ analysis may have the ring of truth. The shorted stock priced may decline.

Sooner or later, the managers of the targeted firm learn that a group of short sellers has taken aim at their company’ stock and is trashing it to the press. Not surprisingly, the manager of the targeted firm take a dim view of such activity. They see the short selling as an attack on both their company and their own jobs as managers. The managers of the targeted company often decide to counterattack. The managers who decide to fight the shorts can take various steps, including threatening to sue the short sellers and/or urging shareholders to request physical delivery of their stock certificates. Shares held in the owner’s physical possession cannot be borrowed to facilitate short sales. Only shares held in the brokers’ street name are available for borrowing by the short sellers. A scarcity of shares available to be borrowed increased the difficulty of selling short.

Research on this issue has revealed that more often than not, when managers do try to fight the short sellers, the stock’s price does nonetheless subsequently decline. Apparently, those managers who take short selling in stride and simply focus on proving the short sellers are wrong by concentrating on improving company performance do okay by their companies. On the other hand, those mangers who declare war on the short sellers are unintentionally signaling to the market that they fear that the short sellers may be correct. Often the short sellers are the ones who have the last laugh.

By Ben Brench

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