The Digest #63
Short Sellers: Heroes or Villains?
Elon Musk is well known for posting stream of consciousness thoughts on Twitter, a habit that got him in hot water in August 2018 when he tweeted that he had funding secured to take Tesla private at $420, which is equivalent to $84 on a split-adjusted basis. This was considered a crazy price by many observers at the time. It turned out that funding was not as secured as Musk implied, a period of volatility ensued, and this was followed by a settlement with the SEC.
As we can see from the chart, Tesla stock is now trading at almost exactly ten times the level at which Musk hoped to take the company private less than three years ago. This was driven by an enormous rally in Tesla shares starting in late 2019. This rally continued until early February 2020, at which point the stock had attracted interest from short sellers including David Einhorn.
Tesla was the subject of a Rational Reflections newsletter issue almost exactly a year ago, on February 5, 2020:
“… at $161 billion, Tesla, as of Tuesday morning, had a higher market capitalization than General Motors, Ford, Fiat Chrysler, and Daimler combined. No matter how optimistic one may be about Elon Musk’s ability to dominate the auto industry (or enter new industries) in the years and decades to come, the stock’s recent rise seems to have its roots in something other than market fundamentals.”
After falling from its February 2020 highs during the early days of the COVID pandemic, Tesla took off like a SpaceX rocket. At a recent market capitalization of $800 billion, Tesla stock has defied the skeptics. It is one thing to make a casual comment in a newsletter and quite another to back that opinion with money. Short sellers have skin in the game — they put their capital on the line and suffer the consequences if they are mistaken.
The question of whether short sellers serve any constructive purpose in our capital markets has come up recently as retail investors sought to “stick it to the man” by creating a short squeeze in stocks such as GameStop. Clearly, Elon Musk was sympathetic to the idea that shorting is socially destructive as he tweeted the following message at the height of the GameStop action last week:
Musk is hardly alone when it comes to disliking short sellers. Very few CEOs of public companies relish the prospect of having a famous investor announce that he or she is short their stock, not only because no one likes a vote of no confidence but because shorts are known for making their research public. Nearly all public companies compensate executives with significant amounts of equity and a stagnant or declining stock price isn’t something a CEO with that type of compensation package wants to see.
However, it is important to not lose sight of the fact that a stock price represents more than a number on a chart or an executive’s compensation. Stock prices are signals that impact capital allocation in the real economy. A company that enjoys a high stock price has an opportunity to issue additional equity to the public, raising capital to fund additional investments. The high stock price is a vote of confidence and a market signal. A low stock price, on the other hand, makes equity raises expensive and expansion more difficult. Stock prices that are untethered to reality can cause misallocation of capital in a market economy.
Short sellers have a major incentive to expose fundamental problems in a business model, highlight cases where a stock’s valuation has simply outpaced their perception of fundamentals, and especially to cast a bright light on suspected fraud. True, short sellers can attempt to manipulate markets, but as we have seen with GameStop, manipulation can occur on the long side as well.
In a recent podcast, Grant Williams interviewed Marc Cohodes and Bill Fleckenstein, two accomplished short sellers, who try to explain the GameStop situation as well as the broader question of what’s behind the anger of many retail investors.
Recently, I posted a link to Mohnish Pabrai’s article outlining reasons for avoiding short selling which perfectly encapsulates why I have avoided shorting and will likely never short a stock. Nevertheless, I appreciate the fact that there are short sellers operating in financial markets. Most shorts are neither heroes nor villains — they are simply trying to make a buck just like traders on the long side.
Atomic Habits
A few months ago, I moved into a new building. Soon after my move, I found that it was getting more difficult to stick to a low carbohydrate diet, and it quickly became obvious why this was the case: I had inadvertently sabotaged myself by moving into a building with a bagel shop occupying one of the ground floor retail locations.
Not only could I see the bagel shop on a daily basis as I walked to the building, but I could smell the bagel shop as well. Sensory overload ensued as the cues piled up, leading to a purchase of a bagel in the morning. Having consumed more than my daily allocation of carbs by 8 am, naturally this led to additional lapses later in the day.
I have an aversion to most “self-help” books, but James Clear’s Atomic Habits is better characterized as a book on human psychology. Fighting the basic psychological impulses that serve as cues in our environment is a losing battle. It is better to design your environment in a way that maximizes your chances of success.
Clear’s book is a quick read and provides a number of actionable insights. I plan to review it in more detail this month. Even before reading this book, I discovered a cure for my bagel problem: Avoid the cues by walking to the building from a different direction and steering clear of the building exit that is adjacent to the bagel shop.
The Miracle of Parks
Without open space, cities become unattractive and less livable. If you think about it, the existence of Central Park in New York City is a miracle given the value of the land. How tempting it must have been for prior generations to encroach on the open space — just a little! — to create more buildings. Open space is a hallmark of most of the great cities of the world.
One of my favorite articles of 2020 was The Evolution of Robert Moses, a man who has receded into the mists of history but played an enormous role in the development of New York City and Long Island. Moses had many flaws but he understood the need for open space in urban environments.
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