- What individual investors should know
- The potential ripple effects and opportunities in the weeks ahead
- How “short selling” works
Estimated read time: 4 mins
Our Concerns, Thoughts and Actions
Recently, a rising number of retail investors that have organized through social media have coalesced with the intention of changing the investment landscape through various means (or perhaps memes?). This includes buying shares in companies that have little value and driving their stock price sky-high. Their primary targets are companies that hedge funds have shorted in large amounts, like GameStop and AMC Entertainment. In the current situation, there are stocks where the number of shares sold short exceeds the number of shares outstanding.
As the increased buying causes the stock to rise, the equity in the short seller accounts gets diminished and the value of the short increases as a proportion of managed assets. Given the leveraged nature of hedge funds, this chain of events usually results in buying the shares they sold short (to reduce their exposure) and deleveraging through cash deposit or by selling shares owned. Deleveraging can be done proactively by the fund, or forcibly through margin calls. This deleveraging process impacts shares of companies that are not directly associated with the short selling phenomena.
Investment Strategy – Half Full or Half Empty
Our view has been that stock prices are relatively high and extended, yet stock returns in 2021 are likely to exceed the returns on bonds and cash. As we expressed our view, which is unchanged at present, we made note of our expectations for increasing volatility and pullbacks of 5%, 7%, 10% or possibly more during the year. With the Fed promising continued monetary support and with additional fiscal stimulus likely, we expect the U.S. economy to grow at average or above average rates, which makes a recession unlikely barring an external shock. Given that bear markets are closely associated with recessions, the odds of a recession/bear market are low.
As we monitor forced selling, which will run its course in the days/weeks ahead, we are focused on several developments with three prominent areas being:
- The potential impact from this selling imbroglio on bank and brokerage firms
- The impact of regulatory changes to the financial system, and
- Looking for buying opportunities in “innocent” stocks that we own or monitor that have declined purely because of forced selling
It is too early to know the extent of the pullback as we do not know whether we are toward the end of this deleveraging process or just the beginning. We will continue to monitor the landscape and become more defensive if signs point to more widespread pain in the financial system. In the interim, we are maintaining current allocations and holdings with the expectation that damage will be limited to those who assumed high-risk strategies and, sadly, some retail investors that got caught up in these transformative developments. As always, our clients can contact us if we may be of assistance or answer any questions.
A Primer on Short Selling
Most people can grasp the concept (and the reality) of how the shareholders of a company’s common stock benefit if the company is profitable. Common shareholders may benefit from profits being deployed in several manners such as – dividends, share repurchases, debt reduction, mergers and acquisitions, and the reinvestment of profits back into the company to finance future growth. Yet the concept and intricacies of short selling are more difficult to grasp for most. Accordingly, with short selling being quite prominent in recent trading sessions and in the media, we offer the following overview of short selling to assist client understanding of such trading activity.
Lincoln Capital is an RIA (registered investment advisor) that is a “long-only” firm. This means we buy, hold, and sell (when warranted) common stocks, in that order, with the expectation of earning attractive returns from dividend income and/or capital appreciation. In trading parlance, the buy is the opening transaction, the sell is the closing transaction, and in between the buy-sell the shares are considered “long” in the account being held.
In contrast, there are speculators that change the order to sell, hold, buy, which means they expect to profit by the stock declining in price. In trading parlance, the sell is the opening transaction, the buy is the closing transaction and, during the period between the sell-buy, the account is considered “short” the shares that were sold.
When an investor sells shares of a company, there are buyers on the other side of the transaction who pay cash in consideration for receiving the purchased shares. To make this transaction workable, the selling brokerage firm delivers shares of the company sold short to the buyer to complete the transaction, with the short position noted in the seller’s account. The short position is a liability that is secured with the sales proceeds, other account securities, and the financial guarantee of the seller. The securities and short position are continually monitored to maintain minimum equity levels to protect the lending broker, bank, or other entity.
Longs versus Shorts – Risk/Reward
Note that when an investor is “long” (owns) the security, the maximum loss the investor may incur is 100% of the investment – it goes to zero value. In contrast, when a speculator is “short” a security, there is no limit to the amount of loss that may be incurred, as there is no limit to the amount that a stock may rise. Imagine the losses incurred if an investor sold short shares of Apple, Microsoft, and many others in recent years – the percentage losses would have been many multiples of 100%. Short selling is clearly a high-risk strategy that we avoid in principle and in practice.
Many hedge funds borrow money from brokerage firms and banks, and then leverage their holdings with the amount of debt typically being 3 times, 5 times, or more, the amount of equity. Investing with borrowed funds can magnify returns to the upside when it works in your favor, yet it also magnifies the losses when things go against you. When highly leveraged, it does not take much of a decline before the equity is wiped out.
About the Author
Sean McGuirk is a Chartered Financial Analyst® for Providence-based Lincoln Capital, a financial planning and wealth management firm. He is a graduate of Bentley University and a board member of the CFA Society Providence.