Don't Get Short With Us

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Uncertainty in the tech market has been bubbling up the last few weeks, leading to some random huge drops in FANG stocks and increased short interest in companies like Apple (NASDAQ: AAPL) and Tesla (NASDAQ: TSLA).

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In this episode of Industry Focus: Tech, Motley Fool analyst Dylan Lewis and senior tech specialist Evan Niu explain why there's so much shorting going on in the tech market, and what it says about the market in general and the tech sector in particular. Find out how short-selling works, what some of the most-shorted companies are today and why, some of the biggest risks that investors need to know about shorting, and more.

A full transcript follows the video.

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This video was recorded on June 16, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, June 16, and we're talking about short interest. I'm your host, Dylan Lewis, and I'm joined on Skype by Fool.com senior tech specialist, Evan Niu. Evan, how's it going?

Evan Niu: Doing well.

Lewis: The news that dominated the headlines today, certainly I had a bunch of notifications about it when I woke up, was the Amazon (NASDAQ: AMZN) -- Whole Foods acquisition, which is pretty crazy. Unfortunately, because of our taping time today, and the availability of the details, we're not going to be able to touch on that. I was a little bummed, because I do love doing those types of shows.

Niu: Yeah, it's pretty big news, I woke up too with the push notifications about it. I think there were rumors about it, something to the effect of Amazon was thinking about this a few months ago, so I don't think people are too surprised. But it is kind of crazy that they went ahead and pulled the trigger on in.

Lewis: Yeah, it's particularly interesting because there was also rumors about Amazon and Slack possibly doing something.

Niu: Right. And that was supposed to be $9 billion. This deal is like $14 billion. It's like, I don't think they have enough money to do all these deals.

Lewis: Yeah. There will be a breakdown with Industry Focus on that deal, but it's going to come on Tuesday on Vince's Consumer Goods show, because we don't have the availability of details or the time to do it right now when we're taping the show. So, look forward to that next week. We are instead going to shift our focus over to some of the uncertainty in the tech space. I think if you look at last week, we saw that weird flash drop that all of the FANG stocks experienced, it was like 2:44 PM on Thursday or Friday and they all dropped around 1.5%. Looking at some headlines that I saw this week, there seems to be some other ominous feelings, at least in the market, two in particular that kind of caught my eye and were the impetus for today's show: "Apple and Tesla's Shares Are Two Of The Biggest Shorts In The World Right Now" -- that's MarketWatch. Then, "Wall Street Is Betting Against Tesla and Alibaba Like Never Before," coming from Fortune. The basis of these news items is short interest in these companies. This is a topic that we've touched on a little bit in the past, Evan, but I figured that today we would take on that topic, talk about some of the different ways short interest can be stated, and then maybe why people are betting against Tesla and Apple a little bit.

Niu: As a quick primary for anyone who's not too familiar, short interest is basically how many shares are being held short against the company. There are a couple ways to look at it, I think we'll touch on these. You can either look at is as a percentage of shares outstanding or, alternatively, percentage of float. I think these headlines you mentioned before measured them in dollar terms, because it makes for a good headline, that there's billions of dollars being bet against these companies. You just look at the number of shares times how much their worth, and you get a number, you get a good headline.

Lewis: So, you mentioned the two different calculations there. If you've seen this data as a percentage, it'll either be basically the number of shares sold short divided by shares outstanding, or the number of shares in short positions divided by the percentage of float. Do you want to talk about the difference between shares outstanding and float? Because I'm sure there's some folks out there who don't really know that distinction.

Niu: Sure. Shares outstanding is pretty much exactly what it sounds like. That's the total number of shares that are out there that a company has issued. But you have to acknowledge that some of their shares cannot be freely traded. The most prominent example of that is all the shares that insiders hold, which is usually very substantial. Insiders have all sorts of restrictions on when they can trade their shares. So, a lot of those shares are considered restricted and not freely traded. So, some portion of shares outstanding is always going to be locked away, effectively. Float is what's left. Float is basically everything that's out there that is readily tradable that is currently trading, pretty much anything that's not restricted. Float will always be less than outstanding. I think, that's why most of the time, when people look at short interest, you can take it as a percentage of float, because you want to know the percentage of what's out there, because obviously the stuff that insiders are holding, they're just sitting on it, and that's not going to affect the market price, because those shares aren't really being traded.

Lewis: And I think when you're looking through those two numbers, just to help you reason through it, the percentage of shares held short or the short interest as stated by float will always be higher. You can't have a higher number of shares in float than in shares outstanding.

Niu: Right. I think both are useful. It's always good to keep an eye on both numbers. 

Lewis: Yeah. Looking at some of the numbers that catch your eye when you're looking at the companies by short interest, if you're going by shares outstanding, GNC Holdings is near the top with over 40% of shares currently tied to short. If you're looking by float, Sears is one of the most heavily shorted stocks out there in the S&P 500. They have about 75% of float currently held short. You talked about how you can also do something else with these numbers, and that is assign a dollar value to current short interest. That's what we're seeing with these headlines about Apple, Tesla, Alibaba. The calculation there, as you alluded to, is taking that percentage. For this one, you would want to be using shares outstanding rather than float, and applying it to the company's market cap to see what the actual dollar value is there. And while I do think it can be helpful, I think it's kind of a misleading number when you're looking at a lot of these big tech companies.

Niu: I think it could be framed in a misleading way. For example, short interest numbers are officially disclosed twice a month by the exchanges. You'll get an absolute number in terms of shares. As a reference, Tesla, at the end of May, they're about 31 million shares held short. Apple was about 63 million. But obviously, that doesn't include the percentages. In those intervals, they put out those numbers every two weeks or so, twice a month, but beyond the official numbers, you do see a lot of headlines from third-party companies, the most prominent being S3 Partners, which you see quoted a lot in these articles about short interest. S3 Partners is a financial analytics firm, so they have other ways to measure short interest, in terms of percentage and dollar value, between those official release dates. So, they have their own ways to quantify these numbers. That's where a lot of the time you'll see these numbers coming from as well. 

Lewis: To run through those calculations that we talked about for Apple, to show the mechanics here. Roughly 1.2% of Apple shares outstanding are currently being shorted, and the company is worth about $750 billion. So, that's how you get to $9 billion in value being held short, which is one of the highest dollar amount currently out there for any companies that are publicly traded. I think it's worth revisiting that context. Apple is a massive company, and when you're that big, you're going to be near the tops in a lot of major categories. As the case in point, they have a 1.75% yield with their dividend, they are currently the world's largest dividend payer. So, I think the scale gives you some good things and some bad things when you're that big.

Niu: Right, exactly. In absolute terms, yeah, Apple is the biggest dividends player. But on a percentage yield basis, it's really modest, like 2%. It's nothing too big. It's just one of those, when you're the biggest company in the world, pretty much everything you do is going to be very big.

Lewis: I like to think of it, for any baseball fans out there, like Hall of Fame pitcher Cy Young. He's the pitcher that started the most games in MLB history, so he easily has the record for most wins. He also has the record for most losses in baseball history. So, there are going to be some numbers that look really good when you're working at big scale, and there are going to be some numbers that look really bad. To look at it, on a dollar-value basis, how some of these other companies stack up, the top five are pretty much all tech names. No. 1 is Alibaba, No. 2 is Tesla, No. 3 is Apple, No. 4 is AT&T, and No. 5 is Amazon. They're all big companies there. I don't want people to get too caught up in that dollar value number, because I think there are more important things to keep in mind, and I think it's always good to look at the percentage side of short interest, because a lot gets lost when you're looking at it in dollar terms.

Niu: Right. There's a lot of ways to read the percentage, too. The most obvious is, a large number means a lot of people are betting against it. But, you also have to remember that short-sellers inevitably do have to buy back those shares eventually, so you could also see that number as picked-up buying demand for whenever those short end up closing out their positions, either at a gain or loss, depending on what's going on. But, I think it's important to keep in mind, even if there's a bunch of people betting against whatever stock, they do have to buy that back eventually. They can't just keep it down forever.

Lewis: Yeah, you often hear the term "short squeeze." That is that people are being pinched when they're in that position, and are looking to cover their spots there. Looking over at the rest of that list, to ease people who have any concerns about what's going on in the tech market right now -- we'll talk about some of the individual companies -- if you look at, on a dollar value basis, the top 20, there are a lot of really big names in there. Visa, Bank of America, Wal-Mart, Chevron, they're all in the mix. So, again, I think this is more an issue of scale than it is that the tech sector in particular is wildly overvalued and people should be scared. We looked at how the short interest for Apple specifically is very low when you look at their shares outstanding, but that's not necessarily the case with Tesla. Why don't we walk through what's been going on with them with short interest, and maybe with some of the concerns that current shorts have with the company?

Niu: Tesla is a very polarizing stock. You either love them or hate them, there's not really much in between. I think the main short thesis is primarily predicated on valuation, because if you compare Tesla's valuation to many other auto companies, it looks absurd and completely insane. The never-ending debate is: Do you consider Tesla a tech company or an auto company? They trade like a tech company, but is that warranted? It primarily revolves around the valuation argument, which is really hard when Tesla doesn't have any direct comparable peers, because they are very different from automakers. But, of course, their operations are dominated by making cars. There's never going to be an answer, because it's going to be a never-ending conversation. All the while, the shorts are betting against the basic valuation. But, if you remember, there's that old adage: "The market can stay irrational longer than you can stay solvent." So, even if you're right, the market can continue doing its thing, and you can get squeezed out. Even if you're right, but it takes a long time for your thesis to play out, are you willing to hold on that entire time? Tesla has this incredible story, they have Elon Musk and everything he says makes headlines. I also have a theory that everyone wants to invest in Elon Musk, and Tesla is the only publicly traded company of his, out of his dozen companies that he runs and operates. So, I feel like some of the general interest in investing in Elon gets consolidated into Tesla, because you can't buy SpaceX, you can't buy his tunnel company. Tesla is the only one you can buy. If you want to invest in Elon somehow, that's how you do it. So, I think that contributes a little bit. But, it's really hard to bet purely on valuation. Of course, they do point to some of Tesla's mistakes and challenges, and there definitely are some. But are those fatal types of operational issues? Or is it something they can get over? So, I think that's the challenge with the short thesis for Tesla. And let me say really quick, I do think it's kind of insane that Tesla is almost $400 [a share] when two months ago it was a big deal when they hit $300. So, it is getting kind of crazy.

Lewis: And you're saying that as a long-term Tesla shareholder. I am also a Tesla shareholder, and I kind of agree with you. Every time I check my brokerage, it's up 1%-2%, gosh, pretty much every day. So, I understand why people are like, "This can't continue, we can't sustain this." At the same time, it is a company that has proven the shorts long for a very long time.

Niu: Right. Tesla trades almost entirely on sentiment, it's all based on sentiment. The current fundamentals don't have much bearing on it. Like most growth companies, it's all baking in the future possibilities, and that's going to create a lot of uncertainty and volatility in the short run. I'm long and I'm getting a little nervous at these prices. But, at The Motley Fool we're long-term-focused, so we're probably just going to sit on our hands. But, objectively, it's getting kind of crazy.

Lewis: It is. But, it is dangerous, those lofty valuations that Tesla and Amazon sport, they are a reflection of the fact that they're very dynamic, and the danger of betting against a super dynamic, very nimble company is that they roll out or decide to finally break out financials for a segment that they've been kind of cagey about, like AWS with Amazon, and all of the sudden you have this massive profit center that just skyrockets the stock and shows there's clearly something viable here beyond what they were doing an e-commerce, which is something that happened a couple years ago. So, I think in tech in particular, being on the short side of things is very risky. While looking at short interest can be helpful to understand how people feel about a stock and what the market sentiment is, I will revisit that episode that you and I did two months ago or so when we were talking about the risks associated with shorting a stock. If you haven't listened to that episode, I highly recommend it. And listeners, if you have any trouble finding it, write into the show, industryfocus@fool.com, we'll be sure to get it over to you. We touch on a lot of the basic ones there. We talk about how valuation and share price can go up, and you'll be kind of squeezed there. That is not the only risk when it comes to being short a stock, right, Evan?

Niu: Yeah, there are plenty of risks. But I think there's one in particular that most people are not aware of. That applies to all short-selling, and that's the fact that your broker, if you go short a stock, can buy you back in and close out your position at literally any time. And that's a huge risk, because if you go long a stock, that doesn't apply, because you choose when you want to sell. But if you go short a stock, your broker can choose to close you out. And the reason why that is is, if you think about it mechanically, when you short a stock, you're borrowing shares from someone, and when you close out you buy back the shares and return those shares. But, where does the broker get those shares? The broker gets those shares from other investors. So if someone takes out a margin loan to invest, they're basically allowing the broker to use their long shares as collateral for that loan, through a process called hypothecation. So, if that investor, for whatever reason, pays off their margin loan, either by selling stock or putting money in their account or whatever, the broker can no longer use those shares as collateral, because there's no longer a loan there. So, you turn around, and whoever they had been previously lending those shares to, they no longer have access to those shares, so the broker just closes it out because they can't lend you those shares anymore. So, I think that is, in general, a risk. It doesn't happen a lot. But back when I was a broker, I used to get calls and people would be like, "Why did you buy me back in?" And that's the answer, because we no longer had access to those shares, so we had to close out their position. And when the broker does that, they don't care where you're at on the trade. You could be up or down, but they have to do what they have to do, and then your position is gone. So, I think that's a general risk. And certainly it's more pronounced for stocks that are hard to borrow, when there's really not a lot of supply of shares to lend. But, yeah, if you're going to go out and short a stock, there's tons of risks. That's one of them that most people are not as aware of that I think they should be.

Lewis: I'm glad you were able to draw on some of your broker experience and bring it into the podcast, because often, before the show, we wind up shooting it for a little bit, and you always have some interesting stories to tell. Evan, anything else before I let you go?

Niu: No, I think we covered it, I think that does it.

Lewis: Just a little housekeeping note before we wrap up -- listeners, you know we work with advertisers to support the show. One of our sponsors is running a survey to get a better sense of the podcast consuming audience. If you want to give them a hand, head over to podcastlistener.com/fool.

That does it for this episode of Industry Focus. If you have any questions, or just want to reach out and say, "Hey," you can shoot us an email at industryfocus@fool.com, or tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out the Fool's family of shows at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan, for all he does behind the glass. For Evan Niu, I'm Dylan Lewis, thanks for listening and Fool on!

John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Dylan Lewis owns shares of Amazon, Apple, Tesla, and Whole Foods Market. Evan Niu, CFA owns shares of Apple and Tesla. The Motley Fool owns shares of and recommends Amazon, Apple, Tesla, Visa, and Whole Foods Market. The Motley Fool recommends Chevron. The Motley Fool has a disclosure policy.