Hindenburg Lands the Airship

Despite yesterday’s stellar rally, I have probably discussed the news that Hindenburg Research is closing up shop more than any other topic today.  The obvious reaction was that it shows another bear throwing in the towel.  But I believe this situation says much more about that specific business than the overall market.

To be clear, I’ve never dealt with Hindenburg or its founder, Nate Anderson, but I have plenty of experience trading from the short side.  Short selling is a necessary skill for a professional trader – especially an options market maker.  By definition, a market maker is continuously posting two-sided prices, so it is typical for someone to be buying options from him at any given time.  Or, the market maker might be buying calls or selling puts, requiring him to sell stock short to remain hedged.  I view a professional trader who is uncomfortable trading from the short side like a basketball player who can’t dribble or make a layup with either hand.  To be truly successful, one can’t be tied to one specific methodology.  As a result, I view short selling as lubrication that ultimately helps the stock market engine to function properly over the long term.

I laid out that philosophy a bit over a year ago in a piece entitled “In Defense of Short Selling”.  I encourage you to read the linked piece, but here are some of the key points:

It is understandable why many choose to demonize the practice of short selling. If there is virtue in buying low in the hopes of selling high in order to support the companies that are the backbone of every capitalist economy, it stands to reason that the inverse – selling high in the hopes of buying low – would strike many as unpatriotic or unethical.  But that is an inappropriate comparison. Just as savvy investors seek to profit from finding undervalued shares, short sellers seek to profit from finding overvalued shares. Neither case involves a moral judgment, yet one is often viewed through a moral lens.

Short sellers understand the risks, and they also understand that they face significant disadvantages. Foremost is the fact that there is an asymmetry of risks and returns. When you buy a stock, you know that your potential loss is limited to your initial investment but that your potential gain is unlimited. The opposite is true for short selling. The stock can’t fall below zero but can rise infinitely. 

Next is that short selling is more costly than buying. One can pay cash for stock. The money is spent up-front, no margin interest payments are required, and any dividends are reaped by the owner. In contrast, every short sale involves margin. Legal short-selling – requires the seller to borrow the shares that they must deliver. Remember, the buyer doesn’t know who is selling him his stock. They only know whether the stock is delivered to their account, not by whom or how. There is a cost to borrowing those shares, and that cost can be quite high. It can, and often does, move higher with little or no warning. That means that the short seller is paying interest constantly, along with compensating the owner of the borrowed shares for any dividend payments. (This IBKR Podcast, where I interview our North American stock lending manager, explains the process in greater detail.)

And perhaps most importantly:

Healthy companies don’t go to zero simply because there is an abundance of short sellers.

Yet I recognized the following factor, which applied directly to Hindenburg and its ilk:

Many people have an understandable distaste when short sellers make unflattering comments about their targets. “How dare they try to talk these stocks lower? They’re just talking their book.

Indeed, that was the feature of Hindenburg’s business model that seems to have led to its founder’s decision to call it quits.  They were activist investors, but from the short side.  They took large positions, then announced them publicly.  At a minimum, that is the distasteful practice of “talking one’s book.”  At it’s worst, it’s illegal – which is what the SEC alleged in July in a $20 million complaint against short-seller Andrew Left and Citron Capital.  Market practitioners are rarely fans of those tactics (at least when they’re employed by someone else).

Furthermore, Hindenburg went after some particularly huge whales like India’s Adani family and Carl Icahn.  Those are undoubtedly targets who did not go down without a fight – and their stocks did recover somewhat – which probably contributed to the Wall Street Journal’s comment that “Hindenburg’s work was followed closely by regulators and law enforcement.”  I’ve never dealt with law enforcement (thankfully!) but adding close regulatory scrutiny to an already difficult business model must be extraordinarily unpleasant.

I’ve often been quite skeptical when a prominent business figure retires to simplify their life or to spend more time with the family.  But in this case, I believe Mr. Anderson.  He’s 40 years old, make plenty of money, and engaged in an incredibly difficult business.  I don’t blame him at all for calling it quits.  But while this might signal the end of the activist short seller model, I don’t believe this has ramifications for the market’s direction, or even the practice of short selling.  We still see plenty of short selling – our stock loan department is in no danger of closing – but the days of attracting attention to one’s short bets is clearly behind us.  Too many investors have found success in finding heavily shorted stocks and participating in social media fueled short squeezes. If there’s money to be made in the practice of shorting overvalued companies, it is now best done quietly.

Go Source