“Persecution is the first law of society because it is always easier to suppress criticism than to meet it” – Howard Mumford Jones

Over the past year, there has been an outcry from company executives and the investing public about short-selling. Short sellers have been blamed for reaping profits from the downfall of good companies with their “bear raids” and “rumor mongering” while John Doe is left to suffer the losses. And if you believe that, you probably think that Bear Stearns and Lehman were fine institutions that would have prospered if not for those nasty bears. In an effort to educate the general public, I am going to discuss the mechanics of a short transaction, the rationale behind a short transaction, the benefits provided by short sellers to the markets, and why blaming short sellers for your losses is simply “passing the buck” and not taking responsibility for your own poor investment analysis. (See my article on taking control of your money and your life.)

1. Mechanics of a short transaction
The first question I always get is “How can you sell something you don’t own?” Well, let’s take a step back and examine a regular buy and sell transaction. First, assume that every share of XYZ stock is issued on a stock certificate. When you buy 100 shares of XYZ at $10 in the market, you send $1,000 and in exchange 100 XYZ stock certificates are sent to you. The following week XYZ is selling for $15 and you decide to sell your stock certificates. You send your 100 XYZ stock certificates to the buyer in exchange for $1,500 (nice trade!) This is not only pretty easy to understand it is also what happens when you buy stock except that the stock certificates are usually held at your broker. So, now let’s look at a sell short and buy to cover transaction. XYZ is trading at $25 in the market and you feel that the price is too high. You go to your broker and ask them if you can borrow 100 shares of XYZ that you will return to them at a later date. IF, and only IF, your broker is in possession of someone else’s stock certificates, they can lend them to you. Once you are lent the shares you can sell them (the shares you have borrowed from your broker) in exchange for $2,500 cash which goes into your account. The next week, XYZ is trading at $15 and you go back to the market and spend $1,500 to buy back 100 shares. You return the 100 borrowed shares to your broker and pocket the $1,000. This is how it works. As for “naked” short selling (shorting without first finding someone to borrow shares from), this has been illegal for years and continues to be illegal. I do not endorse it and no legitimate short seller practices it.

2. Why do it?
This is a personal preference question mostly. However, my answer is that it provides flexibility. If a stock is not cheap enough to buy, it may be expensive enough to short. You have effectively doubled your pool of investment options in equities. Oftentimes, the best shorts are companies that are frauds (think Enron), fads (Crocs and Heelys), and failing business models (Sirf, Sierra Wireless, Novatel). If you a smart enough investor to do the homework and realize that the value being ascribed to a company is fair beyond its intrinsic value, why shouldn’t you be allowed to profit from it?

3. What’s the benefit?
Short sellers provide a few benefits. First, they act as a check on promotional/fraudulent management. They make Dick Fuld and Jimmy Cayne back up their comments that their firms are fine (Lehman and Bear were fine the day before they went under.) Second, they provide liquidity that would otherwise not exist. This point is easy to make in the current market circumstances where the lack of bids and offers is making trading much more difficult. Third, short sellers provide natural future buyers. If you remove short selling from a market , you can effectively remove all bids. If you want proof, ask China. They saw their market go down 75% from the peak in a straight line essentially and they didn’t allow short selling either. I blame Christopher Cox and the SEC for creating an air pocket in September by banning short selling in financials that exacerbated the fall in October.

4. Caveat Emptor
The worst consequence of all this “shoot the messenger” talk is that people feel comfortable blaming short sellers for their losses in the market. Instead of taking responsibility for their losses or poor analysis, they feel they can attack those that have actually done some work. That is capitalism at its worst. Short sellers are providing a service to everyone by keeping markets honest – Warren Buffett has said as much if you need me to appeal to a higher authority.

I leave you with this thought: Of all the CEOs that have publicly complained about short sellers driving their stock price down, how many of them had a real business when the truth was finally out? Here’s a list to start your research with — LEH, BSC, ENRN, OSTK. If a company has an intrinsic value and a real business model, short selling can do nothing more than temporarily distort the value. So whether you choose to employ short strategies or not, please understand that it’s nothing personal. It’s valuation at work.