Batman strikes – Some Thoughts on Short Sellers

Gotham_City_Hedge_FundIn the bad old days of the 2008 Crisis, a casual reader of the financial news might have been fooled into thinking that “short-sellers,” those financial firms that bet on the price of some financial instrument (like a stock, or bond, or currency, or commodity) going down, rather than up, ranked on the financial attractiveness scale somewhere between Renee Zellwegger and Quasimodo – simpering, disfigured, unpatriotic, and untrustworthy.

For a brief time in the midst of the October 2008 panic, the financial regulators nearly outlawed short-sellers, as if there was some moral difference between short sellers and their counterparts “long buyers.” (We don’t refer to them of course as “long buyers” but rather ”investors,’ but finance folks do use the ‘shorts’ and ‘longs’ monikers when describing market participants.)

Only people who have never participated in financial markets could reasonably argue that ‘short selling’ has any better or worse effect on markets than ‘long buying.’ In fact, brokering most markets absolutely requires short selling, both to offer a product to a client that the broker does not currently have in inventory, as well as to hedge purchases from a client that a broker can not immediately dispose of in the market.

When a client needs to sell a block of a stock, or a pile of bonds, the broker will often sell (sometimes selling short) a similar-characteristic block of stocks or bonds right away, to minimize the market-directional risk of holding the client’s recently dumped position. The ability to sell short, for a hedge, is a key tool in the arsenal of brokers.

Short-selling by hedge funds

The ability to short sell is also the fundamental differentiating tool of 80% of hedge funds vis-a-vis mutual funds: Namely, the former can sell short a stock (or bond, or currency, or commodity) whereas a traditional mutual fund may only deploy money on the ‘long’ side, by buying a financial product. Financial products tend to go both down and up, but your typical mutual fund may only be able to deliver a positive return when the markets go up in aggregate.

A hedge fund by contrast – in theory at least – can deliver positive results regards of the direction of securities or the market as a whole. Or, more frequently, a hedge fund may seek to smooth out investment results through a combination of shorts and longs – achieving an acceptable positive return while delivering a ride with less volatility. In that sense your hedge is acting like a Lexus in city traffic – you won’t necessarily get there any faster but the shock absorbers will deliver a much less bumpy and therefore more pleasant ride along the way. At a much higher cost, of course.

Short-sellers as heroes

All of this explanation I intend as prelude to this week’s story about the Spanish tech company Gowex, in which dedicated short-sellers actually prove themselves not only on a moral plane with the Clinton-formulation abortion (“legal, safe and rare”) but actually clever, necessary, and heroic.

gotham_city_hedge_fund

Enter Gotham City Research LLC, a hedge fund dedicated to short-selling as a primary strategy. As the Wall Street Journal reports, these guys – and similar-strategy firms like them such as Jim Chanos’ Kynikos Associates that took down Enron, and Carson Block’s Muddy Waters Research that took down Sino-Forest Corporation – look to sniff out frauds and bet heavily against them through short-selling.

Gotham City swooped down like the caped avenger and exposed the Gowex fraud in Spain.

As recently as July 1st Gowex was a Spanish high technology of the markets, providing free Wi-Fi to municipalities. They boasted the following credentials:

  • A $2.6 Billion valuation in April 2014
  • In May 2014 Gowex won the top prize from a Spanish marketing association
  • Gowex Founder Jenaro Garcia was the 39th richest Spaniard, with an (on-paper) net worth north of $240 million.

After Gotham City released its report July 1st, claiming 90% of Gowex’ revenues were nonexistent and that Gowex is ‘too good to be true,’ the firm’s stock began to nosedive. After briefly denying the reports and accusing Gotham City of trying to benefit through short-selling, Garcia resigned and asked for forgiveness. Gowex filed for bankruptcy by July 6th.

That is some Batman-style, hard-core, swift justice.

People don’t generally love dedicated short-sellers, because they  profit when other people lose money. The Gotham City vs. Gowex story this week is a great example of why we need these mysterious caped avengers in the cityscape, broodingly seeking out wrongdoers.

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