Gordon R Clarke and Emir Hrnjic
GameStop madness and resurrection of short selling myths (as published in The Business Times on February 24, 2021)
By Emir HRNJIC
While the GameStop madness has created numerous controversies, the incident underscores the need to debunk short selling myths, says the writer
In general, short selling typcailly gets singled out during crises as the public hunts for scapegoats
SINGAPORE: A battle of retail versus institutional investors reached its climax when Melvin Capital Management covered its short positions in GameStop at a signficant loss and had to be rescued.
As the price of GameStop soared from U$20 to almost U$500, Melvin Capital Management and other hedge funds with short positions on its shares suffered almost U$20 billion of losses.
While Wall Street investors cried foul, retail investors pointed to the nefarious nature of short selling. As many celebrated hedge funds’ losses, old myths about the trading strategy resurfaced.
Among the most resilient myths remained those that short selling is inherently speculative, it impedes well–functioning of stock markets, and it destroys targeted companies.
Activists called for short selling constraints or outright bans arguing that short selling depresses stock prices and thus the constraints would increase them.
In general, short sellers typically get singled out during crises as public looks for scapegoats. Indeed, a number of European regulators imposed various short selling bans during the COVID-19 pandemic.
But is short selling really nefarious activity? And how accurate is the typical narrative about short selling? More specifically, can the three main myths about short selling be debunked?
Early theoretical finance literature developed opposing predictions with respect to short selling. While some researchers developed models whereby informed short sellers contribute to converging of market prices to firms’ fundamentals, others argued that prices can become less accurate due to manipulative short selling.
In order to solve the controversy, subsequent research dived into the empirical data and uncovered strong evidence of informative trading by short sellers.
For instance, an early research study found that short sellers had trading advantage stemming from their ability to analyse publicly available information. More specifically, short sellers process public news better than other market participants which enables them to make profitable trades.
Another study found that short sellers use both public news and private information to anticipate earnings-related developments.
Taken together, this evidence shows that, on average, short sellers are not speculative traders as they have the ability to process information better than other market participants.
SHORT SELLING IMPEDES WELL–FUNCTIONING OF STOCK MARKETS
Based on data from 26 countries, a seminal study found that stocks with more short sale constraints have lower price efficiency. Moreover, relaxing short sale constraints does not lead to price instability or extreme negative returns.
A more recent research provided evidence that the relaxation of short sale constraints in China and the United States improves price efficiency by providing incentives for short sellers to produce information.
Utilising a natural experiment in the aftermath of COVID-19 pandemic, researchers exploited differences between different short selling regulations in various European financial markets.
More specifically, a number of European countries which introduced temporary bans on short selling activity in the period March–May 2020 were compared to other European countries which did not introduce short selling constraints.
The study found that market liquidity deteriorated after the introduction of the short selling ban.
Another study also found that, “during the [COVID-19] crisis, banned stocks had higher information asymmetry, lower liquidity, and lower abnormal returns compared with non-banned stocks.”
Taken together, this evidence shows that stock markets benefit from short selling as prices better reflect the fundamental values. In contrast to the myth, short selling actually contributes to well–functioning of stock markets.
SHORT SELLING DESTROYS TARGETED COMPANIES
A recent research paper analysed managers who were deciding whether to abandon value-reducing decisions. The researchers found that managers of firms whose stocks are less subject to short selling constraints were more sensitive to stock price changes than managers of other firms.
This is consistent with the notion that managers learn more from stock price movements when there are less short selling constraints.
Another research study tapped a natural experiment whereby one-third of the Russell 3000 index were exempted from short sale constraints. The results were consistent with the notion that short selling reduced earnings management, helped detect fraud, and improved price efficiency.
Similarly, another study found that banks whose securities were subject to short selling bans had an increased probability of insolvency.
Finally, short selling constraints act as a limit to arbitrage and impede well-functioning of stock markets. A research study found that more short selling risk leads to less short selling and, (more importantly for this article) less price efficiency and lower future returns.
While the public typically turns against short sellers during crises, academic finance literature is almost unanimous that short selling constraints or outright bans cannot stabilize financial markets during crises.
On the contrary, short selling constraints are more likely to undermine the market efficiency, reduce liquidity, and lower future returns.
While short selling may have costs, the myths about speculations, impediment to markets as well as destruction of companies should be decisively debunked.
GameStop insanity has painful lessons on short-selling and more for retail investors (as published on ChannelNews Asia on February 5, 2021)
By Emir HRNJIC
While the story has been framed as a modern David versus Goliath tale, the incident underscores the need to educate retail investors of investment risks, says NUS Asian Institute of Digital Finance’s Emir Hrnjic
SINGAPORE: In the recent battle on Wall Street, retail investors soundly defeated hedge fund billionaires at their own game and decimated hedge fund Melvin Capital Management to the tune of several billions of dollars.
A group that initiated this battle and declared war on Wall Street – Reddit’s WallStreetBets forum – doubled its membership to more than 6 million members in just a week.
In a sign of support, the progressive Representative Alexandria Ocasio-Cortez said: “Everyday people were finally able to proactively organise and get back at the folks that have historically had all the marbles on Wall Street.”
With memories of the Great Recession still fresh in their minds, average people around the world celebrated this rare win of David over Goliath.
But was that really the case? And what really happened?
A video game retailer GameStop has become the centre of a battle between an army of retail investors and hedge funds over the past month.
Amid an overall economic slowdown and a gradual shift to digital gaming, GameStop has announced closing hundreds of stores due to a stark drop in sales. In the mid-2020, however, new leadership took over the company.
The company with declining prospects, but promising new leadership, found itself in the middle of heavy short selling by hedge funds.
Short selling is a very risky strategy. When shares of the company are heavily shorted and share price starts going up, short sellers are forced to close their positions and buy shares at higher prices, thus creating buying pressure.
Moreover, rising prices trigger margin calls creating even more pressure on short sellers. This leads to a self-reinforcing loop and a so-called “short squeeze”.
Enter Reddit’s WallStreetBets forum – a community of self-proclaimed “degenerates” who treat stock markets like casinos and feel a sense of responsibility to stand up to financial institutions that have rigged the system.
These renegade retail investors self-organised and started investing against institutional investors – self-proclaimed “smart money”.
They started promoting GameStop and encouraging members to buy its shares in a potential ramping scheme designed to artificially inflate the share price and create a short squeeze.
In the second half of January, price of GameStop went from U$20 to more than US$300, for more than 1,500 per cent return, while decimating short sellers in process.
Melvin Capital Management suffered billions of dollars of losses, while losing more than 50 per cent of its value in January and had to be rescued. Short sellers’ losses amounted to almost U$20 billion – more than the market cap of GameStop.
DAVID VERSUS GOLIATH?
Business press promoted a simplified version of the story and labelled it the battle of David versus Goliath. But there is more to the story.
Some data suggests that sophisticated investors with access to plenty of capital joined the buying side. In fact, even after broker apps like Robinhood banned retail buying, thus cutting retail investors’ main access to shares of GameStop, buying pressure continued.
While media reports continued the narrative that retail traders were buying frantically and retail sentiment kept the buying pressure, Bloomberg reported Citadel Securities’ retail flow which looked pretty balanced. In other words, retail investors were buying and selling in equal amounts. In fact, they were net sellers for most of the last week.
Moreover, GameStop’s largest shareholders were Wall Street powerhouses Fidelity Investments and BlackRock.
If anything else, GameStop’s fever may have initially resembled a conventional pump-and-dump scheme that might have started on WallStreetBets’ forum, but was likely supported by much more sophisticated and wealthier investors.
WHAT IS NEXT?
Many wonder how this will end. What is the exit strategy for GameStop shareholders?
Remember, retail investors started buying GameStop shares to put pressure on the share price and force short sellers to cover their positions, creating a self-reinforcing buying pressure and, thus, a short squeeze. A typical short squeeze often leads to a price bubble whereby stock prices are not supported by fundamentals.
As is typical in bubbles, some investors are buying out of conviction that the price will keep rising. Even if investors understand that they are buying at inflated prices, they are likely hoping to sell them to “a greater fool” at even higher prices later.
Nevertheless, when all shorts get covered, investors will be stuck with an inferior dividend yield, depressed cash flows, and no incentive to hold.
As it becomes clear that prices are above prices justified by any fundamental pricing model, investors will find themselves holding overpriced securities. At that point, collective action will likely fail and some shareholders will start realising gains by selling overpriced shares.
Once the exodus starts, the price will collapse to a more reasonable level. While early investors will have made hefty profits, late-comers to the party are in for a rude awakening.
At time of writing, GameStop’s price has plunged from a high of US$325 to US$90 a share, where it has stayed for the last two days.
And while some small investors might have won in the short run, investing based on social media posts is a bad investment strategy which will likely lead to an inferior performance in the long run.
But some good came out of this episode. GameStop incident attracted unprecedented media attention to the short-selling and risks of investing in the stock market. The event highlighted a chief need to better educate retail investors about the investing risks.
However, it is not clear that we can rely on the media for investor education. Extremely popular podcast host Joe Rogan created a video about GameStop in which he said: “It’s all so weird… because the stock market has always been this weird number thing that is based on confidence.”
With two million YouTube views in three days, this statement highlights the current (mis)understanding of the issue.
By Emir Hrnjic
The COVID-19 pandemic triggered a massive uncertainty in global markets and the U.S. Fed responded by cutting interests rate to 0.25 per cent. As investors started chasing higher yielding investment opportunities, the somewhat–obscure concept of a Special Purpose Acquisition Company (SPAC) came back to the spotlight. In 2020 alone, roughly 250 SPAC initial public offerings (IPOs) raised U$83 billion – roughly equal to funds raised by conventional IPOs. Moreover, SPAC IPOs in this banner year raised more capital than all previous SPAC IPOs combined. Even 2021 started with a bang raising roughly U$8 billion in first two weeks – on a pace to double the record of capital raised in 2020.
Recently, Asian investors started jumping on a bandwagon. For instance, SPACs sponsored by Asia–based Antony Leung, Richard Li, CITIC Capital, Maso Capital, and Malacca Straits have raised more than U$2.5 billion, while Singapore–based Vickers Venture Partners, Japan–based Softbank, and Hong Kong–based Provident Acquisition recently filed to raise almost U$1 billion via SPAC IPOs. Even the Singapore Exchange is considering allowing SPACs’ listing due to their popularity.
Furthermore, more than a dozen SPACs are holding talks with South-east Asia’s startups about potential mergers. For instance, Bridgetown Holdings approached Tokopedia – South-east Asia’s largest e-commerce platform, while Traveloka – South-east Asia’s largest online travel app – announced that it is going public with a SPAC as a possible option. Moreover, reports revealed that other Asian unicorns such as Grab, Gojek, and Bukalapak have all been recently approached by SPACs.
While Goldman Sachs declared that SPACs in 2021 could even exceed capital raised in 2020 and Reuters reported that SPACs “arm up for Asian unicorn hunt”, investors are getting reacquainted with these alternative financial vehicles.
Known as a “blank check company” with no business operations, SPAC is formed to raise funds via IPO with an intention of acquiring a promising private company within two years. When a private company is acquired by a public firm, it automatically becomes public. Hence, SPACs provide the public an easy access to a mature private equity (PE) investments, while being more transparent than PE, but less transparent than conventional IPOs.
Since investors do not know eventual acquisition target at the time of raising capital, SPAC resembles a flipped IPO process from demand–supply perspective. In a traditional IPO process, investment (company going public) is known and underwriters are looking for investors. In SPAC, on the other hand, lead sponsors find investors first and, then, search for investment (company to go public).
After raising capital, SPAC sponsors promise to identify an acquisition target within two years. If they fail to find a target within two years, most SPACs return money to investors. Even if they find an acquisition target, the SPAC shareholders have flexibility to opt out and redeem their shares before the acquisition.
Also known as De-SPACing, SPAC’s acquisition automatically makes a private company public and thus resembles a flipped RTO from the private–public perspective. While RTO represents the process of private company acquiring a public company, SPAC achieves the same outcome via the process of a public company acquiring a private company.
On the other side of the table, acquisition target has to negotiate with only one party (SPAC) unlike a typical IPO company that deals with multiple parties including underwriters, lawyers, and auditors.
SPAC IPOs VS. CONVENTIONAL IPOs
Natural question arises how SPAC IPOs made such dramatic inroads into well–established world of conventional IPOs.
SPAC proponents claim that the phenomenon of pricing a typical IPO below their market price – so called IPO underpricing – incurs an unnecessary (opportunity) cost for the company going public, also known as “money left on the table”. The IPO underpricing averaged over 20 per cent this year.
In extreme cases, IPOs leave even more money on the table as in recent cases of DoorDash and Airbnb which soared 86 per cent and 115 per cent on the first day of trading, thus leaving billions of dollars on the table.
They also argue that SPAC enables investors to avoid IPO underwriting fees that typically go as high as 7 per cent.
Other factors include reduced underwriters’ ability to conduct traditional IPO roadshows during pandemic. Since SPACs are established by reputable sponsors who then search for additional investors through personal networks, there is no need to conduct traditional IPO roadshows.
Moreover, the quality and reputation of SPAC sponsors have drastically improved over the years and institutional heavyweights such as Goldman Sachs, Citigroup, and Deutsche Bank jumped on the SPAC wagon. The improved quality of sponsors, institutions, and their networks greatly contributed to a SPAC boom.
Additionally, many view SPAC as an accelerated IPO without strict regulatory scrutiny that accompanies a typical arduous IPO regulatory process. SPAC accelerates the process of capital raising as there are no operations, assets, or financial data. The entire process can be completed in several weeks, instead of several months. This efficiency reduces completion risk, especially in volatile markets.
Finally, some spectacular success stories boosted the popularity of SPACs and attracted even more investors. For instance, DraftKings’ valuation quadrupled, while Virgin Galactic’s price jumped 150 per cent in several months after the SPAC acquisition.
SHORTCOMINGS OF SPACs
In contrast, shortcomings and hidden costs of SPACs are numerous.
A recent research study documented that the median SPAC held only U$6.67 per share by the time of the merger – down from U$10 at the IPO stage. This drop was mostly due to dilution of SPAC shares as sponsors were rewarded with 20 per cent of the acquired company – akin to a “finder’s fee”.
Another research study documented that the average SPAC IPO in the first decade of 2000s lost roughly half of its value over four years, while higher SPAC sponsors’ ownership was associated with worse performance. Similarly, the operational performance of SPACs was inferior to industry peers and conventional IPOs.
Finally, research found that SPAC–acquired firms were traditionally small and levered firms with low growth opportunities, consistent with the notion that SPAC acquisitions attracted ﬁrms to go public in difﬁcult times.
A former SEC Chairman, Arthur Levitt, stated “I have never found any [SPAC] attractive. No matter what the reputation or what the sponsor might be. […] They are the ultimate in terms of lack of transparency.”
Notwithstanding the banner year for SPACs, opponents warn that SPAC is inherently inferior capital–raising method. A potential reversal in market enthusiasm may come from increased opposition of target companies, opaque nature, or inferior post–performance.
SPAC sponsors try to convince investors that these statistics derive from SPACs of old era, while new SPACs are bigger, better, and higher quality. Nevertheless, investors should do their own due diligence and do not rely on any sponsors’ promises. After all, sponsors’ incentives are very different than theirs.
By Emir Hrnjic
As COVID-19 pandemic devastated global economy and created an unprecedented uncertainty in global markets in 2020, an alternative financial vehicle known as Special Purpose Acquisition Company (SPAC) flourished as an innovative capital–raising method. In 2020 alone, almost 250 SPAC initial public offerings (IPOs) raised more than U$81 billion – more than all previous SPAC IPOs combined.
While most SPACs are sponsored by investors in the United States, Asian investors started catching up. For instance, Antony Leung, a former Hong Kong financial secretary and Blackstone executive, launched a U$1.5 billion SPAC. Additionally, SPACs sponsored by Richard Li, CITIC Capital, Maso Capital, and Malacca Straits – all based in Asia – have raised more than U$1 billion. More recently, Singapore-based Vickers Venture Partners started a process of raising U$100 million through a SPAC IPO.
When news broke out that Bridgetown SPAC backed by Asian-based Richard Li and American–based Peter Thiel approached Tokopedia regarding potential merger, SPAC’s price soared by more than 30 per cent. The largest e-commerce platform in Southeast Asia, however, remained non-committal about the merger. Soon after, the Indonesian giant backed by Alibaba, SoftBank, and Temasek hired investment banks Morgan Stanley and Citigroup to advise them about going-public process and announced that it is considering traditional IPO.
While Forbes claimed that the “SPAC boom of 2020 is probably the biggest Wall Street story of the year”, business press paid very little attention to shortcomings and hidden costs of these alternative financial vehicles.
SHORTCOMINGS AND HIDDEN COSTS OF SPACs
Notwithstanding historical popularity of SPACs and record-breaking amounts of capital, recent research study from NYU and Stanford does not support the popular argument that SPACs are a cheaper way of going public. In fact, the study documents that SPAC costs are opaque and exorbitant as the median SPAC share value starts at U$10 at the IPO stage, but the median SPAC holds only U$6.67 per share by the time of the merger.
This drop is mostly due to dilution of SPAC shares as sponsors are given 20 per cent of the acquired company as a reward for their efforts in finding a target company. This is akin to a “finder’s fee” in return for leveraging their brand equity for fundraising for the SPAC. While the return to sponsors mostly comes from this reward, the resulting dilution represents the cost to other SPAC shareholders.
Furthermore, investors in SPAC may have different incentives and investment horizons which may not appeal to an acquisition target. For instance, IPO investors may have longer horizons because they invest in the IPO company. SPAC investors, on the other hand, may not be vested in the future of the acquired company.
A former Facebook executive, Chamath Palihapitiya, became the poster boy of SPAC boom, when he sponsored SPAC that later acquired the Virgin Galactic. Since the innovative company like Virgin Galactic will likely take a long time to generate the profit, long-term commitment of initial sponsors assumes oversized importance.
For instance, when Virgin Galactic aborted a recent test flight, its shares fell as much as 6 per cent. More importantly, Chamath Palihapitiya sold 3.8 million shares worth U$98 million, thus sending bearish signals to the market.
Another research study from University of Exeter dubs them “poor man’s private equity funds” because, on average, SPACs substantially underperform comparable companies. The average return in four years following the SPAC IPO is negative 51.9 per cent, significantly worse than an average return of 8.5% by comparable IPO companies. Similarly, SPACs considerably underperform the competitors based on accounting measures such as operating margins and return on sales.
Moreover, SPAC performance is worse when deals are completed just before the deadline for a SPAC acquisition suggesting that SPAC managers become desperate to do any acquisition when facing the impending deadline. Performance is also worse if the deal barely meets the minimum transaction value.
The overall research evidence is consistent with the notion that SPAC acquisitions attract ﬁrms to go public in difﬁcult times. SPAC–acquired firms have lower growth opportunities, higher leverage and smaller size and thus lower quality than traditional IPO firms.
SPAC opponents claim that the boom will likely slow down. As retail investors start entering the market en masse, they argue that investor enthusiasm may lead to unsustainable overvaluations.
Moreover, reduced regulatory scrutiny is a double-edged sword. Although the IPO process can be long and arduous, it was designed to provide transparency, thereby providing sufficient information for investors to make sound financial decisions. Comparatively, the SPAC acquisition process is more opaque, as investors are relying on the brand equity of the SPACs’ sponsors as opposed to carrying out due diligence by themselves.
While less due diligence allows accelerated IPO process and reduces completion risk, it may fail to uncover potential accounting irregularities. For instance, the electric truck manufacturer Nikola’s stock price skyrocketed to U$93.99 before falling to U$27 due to alleged false statements about its technology.
Finally, target companies are increasingly uneasy about being acquired by SPACs as evidenced by a recent example of Tokopedia. For instance, former Google executive who founded Upstart, said that “SPAC feels like reaching the next level of a video game and handing the joystick to somebody else. It’s an acquisition of [the] company despite how it might be described.”
Notwithstanding the 2020 boom in SPACs, the fear remains that boom will turn into a market bubble and eventually burst. Myriad factors can contribute to the eventual slowing down such as reduced investor sentiment, increasing opposition of target companies, accounting misdeeds, eventual poor performance, or regulatory intervention.
Wirecard: The Rise and Fall of a Fintech Giant in Asia (as published in The Business Times on Sept 24, 2020)
By Paul Condylis and Emir Hrnjic