Friday, January 13, 2012

Longing The Shorts

A few weeks ago, potential sources of stock ideas were discussed on this site. The post made reference to contrarian indicators that signal that a stock is hated; this hatred can result in a low price, which value investors love. One such contrarian indicator is a stock's short interest.

Twice a month, the exchanges release how many shares of an issue are held short (with a two-week lag). This can be a helpful resource in not only identifying which stocks Mr. Market hates, but also which same stocks Mr. Market plans to buy later. This is because when a share is shorted, it must be bought back later; as such, a high number of short shares suggests a higher than normal demand for shares in the future. offers a list of the most highly shorted stocks (relative to their floats) on the major US exchanges. It currently contains about 100 of the most hated stocks in the US, and plenty of stocks with value potential litter that list. For value investors looking for potential ideas worthy of further study, this is a decent place to start.

For example, a few spots down the list, both GameStop and Sears can be found, both of which are favoured by some value investors. Obviously, one shouldn't assume that just because these and other stocks are on the "high short" list, that they don't deserve to be hated.

But when sentiment on a stock is extremely negative, value investors should pay attention. As such, one of the best places to look for stock ideas is the short interest list. Not only are these stocks unpopular and therefore cheap, these short shares will have to be bought back in the future.


Hester said...

Saj I enjoy your blog, but I must respectfully say this article is completely wrong.

The vast majority of studies show stocks with high short interest drastically underperform the market generally over the long term. Equal weighted high short interest stocks always underperform over the long term, I haven't seen a study that shows otherwise. However, value weighted high short interest stocks (I.E. stocks with low multiples and short interest) sometimes do and sometimes don't underperform the market (which has a higher multiple) but they do almost always underperform low short interest or short interest agnostic value weighted stocks (stocks with low multiples and low short interest). So in other words when you control for all variables, high short interest underperforms their opposites. This is comparing stocks to stocks in a market, not markets to markets by the way.

There is a multitude of studies on the issue and a google search will discover many. Here is a good balanced study, and one of the most famous and longest term: their only mistake is that they compare high short interest value weighted stocks to market stocks and conclude that high short interest isn't as reliable a predictor of underperformance. However, these stocks are benefitting from being statistically cheaper than the market, so the fact that they still underperform slightly despite being cheaper is stunning, considering low multiple stocks usually outperform by a lot.
Here is a relevant quote from the paper:

"Specifically, for the period from 1976 to 2002, equally weighted (EW) portfolios of NYSE-Amex and (beginning in July 1988) Nasdaq firms with high short interest reliably underperform. These same portfolios over the same calendar time period, however, do not reliably underperform on a value weighted (VW) basis. For example, firms in the 99th percentile of short interest ratios have monthly abnormal returns of –53 basis points (t= -2.44) on an EW basis, but only –5 basis points (t= -0.17) on a VW basis."


Hester said...

Here's why high short interest underperforms:

Stocks with the highest short interest are some of the only stocks in the market where all opinions about the stock from people who would normally risk capital are not expressed. A significant amount of negative opinions on a typical high short interest stock cannot be reflected in the price because the mechanics of short selling are no longer feasible. Some brokerages cannot borrow and the ones that can charge high enough hard to borrow fees to keep many out.

However, all positive opinions on the stock are reflected in the stock price because anybody can buy, the mechanics don't change. So an average high short interest stock includes all the bulls but only some of the bears, artificially inflating the price and lowering future returns. Short squeezes can happen but those are rarer than people think and don't stop the long term underperformance. This is why short sale bans enacted by governments create heavy short term volatility but eventually the stocks underperform because negative risk capital cannot be expressed in the stock price.

So although high short interest stocks are hated, not all the hate is expressed in the stock price.

Furthermore those who short stocks for profit are typically more financially sophisticated, because the unlimited risk inherent in short sales weeds out the bad and uneducated investors early. So if you go long many high short interest stocks the person on the opposite side of your trade is more likely to be more sophisticated than average.

I'm not saying that there aren't high short interest stocks that are great values, but you are fishing for gold in a sewer

Saj Karsan said...

Hi Hester,

I'm not sure what you said that makes my article completely wrong. Nowhere did I argue that buying all the shorted stocks will outperform the market. Indeed, many of the highly leveraged businesses with uncertain prospects on the most shorted lists are stocks I would short myself.

All I'm saying is that it's another good place to see what the most hated stocks are, and a place to sift for gold where others may not venture, as you will occasionally find safely capitalized companies at low multiples that are worth investigating further.

Anonymous said...

I'm OK with the fishing for gold in a sewer analogy. I think many value investors would be OK with it too. As a value investor don't you have separate the value from the value traps?

Anonymous said...

Yeah I agree with Saj on this one. Value investing is about fishing for gold in a sewer. If the gold wasn't in the sewer, it would not be a very good investment.

As for identifying value traps, this is not something that can be done on a sustained level by a vast majority of investors. Identifying value traps is as hard, perhaps harder, than identifying solid growth companies based on fundamentals. You might as well pick stocks based on business fundamentals. The key to value is finding a sufficient number of asset-based discounts, not earnings-based discounts because nobody really has a handle on earnings-based investing except a very small percentage of investors. And a big percentage of those small percentage are just the few lucky monkeys who call coins correctly as they statistically would be expected to.

Forget value-trap identification. Stick to buying a large number of asset-based discounts, and "hope" it outperforms the broader market.

Hester said...


Well saying everything is wrong in the article was maybe an exaggerration on my part but I don't understand what part of "the hate is not expressed in the price of the stock" doesn't compute with the commentors.

The companies are unpopular but some, or even most, negative opinions aren't expressed.

Why search in a specific group of stocks that underperforms the market? Sure you can find good values in the group, but that can be said for any large list of stocks if you look hard enough. Why not promote searching for values among the highest multiple stocks. Those underperform yes, but surely there are some that don't and are big winners.

Hester said...

@12:05 anonymous...

The point is that the groups of stocks you are searching for individual value stocks in should have a higher % of values than value traps. Searching in groups of stocks that reliably underperform is stacking the odds against yourself.

@6:55 anonymous...

What you wrote didn't pertain to my comments at all. I agree that buying a large amount of statistically cheap p/b stocks is a great strategy. Buying a large amount of heavily shorted stocks is almost a guarantee of underperformance long term.

The low p/b heavily shorted stocks underperform the low p/b lightly or normally shorted stocks, so I don't understand why anybody would prefer the former group, other than a naive misunderstanding of the situation...