When it comes to a predictive quality of an indicator, we all know from numerous studies that the low price to book, low PE ratio, high price book to market ratios, low price to sales and high earnings yield all tend to produce future returns which are in aggregate higher than that of the markets. So these indicators actually have a predictive quality about them in a sense that they predict the future returns of a security. In these examples of course, they predict that a security’s price will increase.
As deep value investors or net net investors(as this website is about), we are all about asymmetric payoffs and we believe in the statistical idea of mean reversion. These stocks have been beaten down to such a large extent that the market is devoid of all positive and negative expectations of the security in concern.
So this is an idea that has been expressed time and time again by yours truly. And when such stocks report a positive outcome, least expected by the investing public, the security’s price increase, sometimes quite dramatically in my opinion as I have seen over the years.
What about stocks that have mean reverting characteristics to the downside?
And this is what this article is about.
If you have been a deep value investor for a while now, inevitably, you would have encountered a stock which is seemingly undervalued, and possibly a net net. But some of these stocks are cheap for a reason. They may have a flaw in its corporate governance policies and even worse, employ accounting gimmicky to make their balance sheets and income statements look better.
And many times, these stocks have active short sellers who are proactively shorting the stock. This is where you should sit up and take note. The short interest ratio, which is the percentage of a stock’s float which has been sold short is highly predictive of future returns. A high short interest ratio is predictive that a security’s traded price will go down in time to come. This has been backed by a number of academic studies that I need not go into here.
But perhaps I would like to highlight one.
In a paper entitled “Short Interest & Aggregate Stock Returns” written in 2016 by 3 notable individuals David Rapach from Saint Louis University, Matthew Ringgenberg from the University of Utah, Guofu Zhou from Washington University in St. Louis, the paper elaborates on why the short interest ratio is actually a better indicator of future returns than indicators such as the dividend yield, PE Ratio etc.
Below is an abstract of the paper.
We show that short interest is arguably the strongest known predictor of aggregate stock returns. It outperforms a host of popular return predictors both in and out of sample, with annual r-squared statistics of 12.89% and 13.24%, respectively. In addition, short interest can generate utility gains of over 300 basis points per annum for a mean-variance investor. A vector autoregression decomposition shows that the economic source of short interest’s predictive power stems predominantly from a cash flow channel. Overall, our evidence indicates that short sellers are informed traders who are able to anticipate future aggregate cash flows and associated market returns.
In a nutshell, short interest is highly predictive of the downside in a security’s price. High short interest can signal impending downwards revisions of earnings, cash flows and can also signal negative surprises. Even worse, a professional short seller’s report is highly likely to orchestrate a succession of downgrades by other analysts.
Why is that so?
Short Sellers Represent Smart Money
The short selling profession is a very tough one. Firstly, one would have to borrow the shares, pay an interest to the brokerage firm at hefty rates of up to double digits in percentage per annum. And any received dividends would have to be paid back to the original owner of the shares.
If you buy shares in a particular company, the maximum loss is 100% of the capital. But if you short a stock that goes up big time, your maximum loss is unlimited. So as a short seller, the amount of research that you would have to perform is extensive so as to get an information edge over the market.
Hence, short sellers as a whole really have to do their due diligence and really dig into a company’s financials to find out if a company is worth the trouble, the effort and of course the risk. Because as they say, the markets can remain irrational longer than you can remain solvent. In the case of short selling, that is exactly the case because markets can rise indefinitely. And of course, Charlie Munger’s idea of a lollapalloza effect taking hold of a stock can really cause sleepless nights for a short seller.
In aggregate, short sellers within a company represent a whole lot of smart money. And smart money backed by tremendous amounts of due diligence can often cause a stock’s price to crumble like a house of cards.
So this brings me to the final point which I would like to make after all this hullabaloo.
When it comes to deep value, net net stocks which have active short sellers touting its demise, that is something that I would like to stay away from. I have seen short sellers physically counting the number of stores that a company reports to have. The willingness to do some on the ground sleuthing and talk to a company’s competitors, suppliers etc all make the job of a professional short seller a tough one. Indeed, I take my hats off to them who do it well. But at the same time, I also know that they more likely than not have an informational edge over me. This is a risk that I am not willing to take.
In any case, this is the conclusion from the paper.
In this paper, we find that short interest, when aggregated across firms and appropriately detrended,
is a statistically and economically significant predictor of future market excess returns over our
1973:01 to 2013:12 sample period. In fact, our short interest index is arguably the strongest
known predictor of the equity risk premium
As always, may you be blessed with prosperity, health and happiness!
Would you like a short case study of a stock which has active short sellers. Read this little one here.
These books which I have written are case study driven and discuss strategies, mindsets and situational approaches to employing the net current asset value strategy.
What Is TheHolyfinancier About?
- A database of net net stocks or net current asset value stocks
- Investing ideas in members section
- Blog articles and investing education
- Investing research of deep value stocks