Stocks: Why Investors Should Want More Short-Sellers

By Markets Fool.com

It appears all the optimism about hostile takeovers and progress on Greece's economy was wrung out of the market yesterday, and stocks are essentially unchanged Tuesday, with the Dow Jones Industrial Average and the broader S&P 500 up0.01% and down 0.09%, respectively, at 12:35p.m. EDT. The technology-heavy Nasdaq Compositewasdown0.15%. With stocks back near their May all-time high, life isn't easy for short-sellers, who bet on stocks' decline by borrowing shares and selling them in hopes of buying them back at a lower price. Here is why long-term, value-driven investors ought to lament short-sellers' plight, rather than rejoice in it.

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Yesterday, the Financial Times' Alphaville blog highlighted the dearth of dedicated short-sellers, citing data from HFR that showeda grand total of 17 "short bias" equity hedge funds. These funds control less than two-tenths of a percent of the industry's total assets under management.

That's not all that surprising. In fact,a single chart does a pretty good job of explaining why that might be:

^GSPC Chart

^GSPC data by YCharts.

Short-selling is a tough way to make a living, particularly in the huge rally off the March 2009 bottom during which the S&P 500 has more than tripled and the Nasdaq quadrupled (and that's before dividends, for which short-sellers are liable). Not every stock goes up in a bull market, of course, but most stocks do have a positive beta (when the broad market rises, positive beta stocks rise in some proportion to the market's gain).

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Furthermore, being right on a company/stock won't guarantee a profit when you're selling the shares short. When you own the shares of a high-quality business bought at a reasonable price, the odds of incurring a capital loss in the long run are essentially zero. With short-selling, timing is much more crucial -- you might never make it to the long run in order to be vindicated.

Take the case of Chinese solar panel company , for example. On Jan. 8, the Financial Times reported that "short sellers are sitting on potential losses of more than $300m in a little-known Chinese solar company whose stock has soared in spite of their heavy bets to the contrary." It's certain that some of these short-sellers were forced to close out their bets at a massive loss.

Just four-and-a-half months later, Hanergy's meteoric rise came to a dramatic halt. "Hanergy shares suspended after 47% plunge," read the FT's May 20 headline. The shares, which are listed in Hong Kong, remain suspended to this day.

In short (so to speak), short-selling becomes increasingly painful, and short-sellers less numerous, as valuations become more and more excessive -- which is exactly when investors would benefit most from their tempering effect on share prices.

Short-sellers are also needed in an environment in which companies are becoming increasingly brazen with their creative accounting. In an excellent New York Times article published last week, Gretchen Morgenson cited data from The Analyst's Accounting Observer, according to which "for the five years that ended in 2013, he found that the number of cost items excluded from the reports of 104 large technology, health care and telecommunications companies had risen to 504 in 2013, up from 365 in 2009."

These exclusions are not incidental. As Morgenson pointed out:

Investors may be focusing on the revenue growth at Salesforce.com . ... But when Salesforce.com computes its executives' cash incentive pay, its $146 million operating loss turns into a $574 million operating profit. This transformation occurs because the company excluded $565 million worth of stock grants awarded to employees last year.

Mind you, that hasn't gone completely unnoticed. Investors have sold short 3.2% of Salesforce's stock, putting it in the top quintile of companies traded on U.S. exchanges with a market value in excess of $10 billion. Perhaps there's hope yet.

The article Stocks: Why Investors Should Want More Short-Sellers originally appeared on Fool.com.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Apple and Salesforce.com. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.