We recently discussed a curious lawsuit filed by small pharma company Biovail against hedge fund SAC Capital Management. Among other things, Biovail alleges that SAC colluded with another firm, Gradient Analytics, to issue research reports that would drive down the price of Biovail’s stock, so that SAC’s short position in Biovail would increase in value.
We’ve been interested to see that a relatively large group of mainstream media -- including The Economist, The New York Times, Business Week and CBS’ “60 Minutes” -- have dedicated significant coverage to the Biovail lawsuit within the last 10 days. The fact that there has been coverage is not so amazing; after all, that’s what “litigation support” public relations strategies are intended to do.
But the fact that media are covering the Biovail suit (and another filed by Overstock.com) as a battle between forces of “good” and “evil” seems remarkably overblown. Business Week’s headline captures the tone of the wave of coverage: “Street Fight: The Secret Lives of Short-Sellers; The rise of hedge funds and indie research raises new questions about a shadowy world.”
It is true that investors using short-selling tactics can make life miserable for corporate management. We’ve worked for companies that have been “attacked” by short-sellers, and, in the short term, stock prices can indeed be affected by a concerted short campaign to “expose” problems at a company. For an investor relations person, there are few moments as horrible as the day when it becomes apparent that shorts are taking a run at your company. The number of phone calls from analysts increases exponentially, and conversations sound more like depositions than discussions. Conversely, there are few moments as sweet as when short-sellers are squeezed out of short positions because their fundamental premise is proven false.
The reality is, though, that hedge funds and other short-sellers cannot cause stock prices to decline for anything other than the short term, unless there is a valid reason for the decline. This truth is a corollary to a basic premise of security analysis: in order for the price of a stock to increase over the long term, there must be a valid, fundamental reason for a higher valuation.
Jim Chanos, founder of Kynikos Associates, is now credited with having instigated the exposure of Enron’s accounting issues. At the time, Kynikos had a large short position in the company, because Chanos was convinced that Enron was a house of cards. (“Kynikos” is Greek for “dog-like,” referring to the types of companies Chanos hopes to identify.) Contrary to the assertions being made by Ken Lay’s and Jeffrey Skilling’s defense teams at the Enron trial, Chanos and other short-sellers did not cause the stock price to decline and could not have been able to bring sustained investor – or regulatory -- attention to the issues if there were no substance to Chanos’ claims.
In discussing Leslie Stahl’s “60 Minutes” story on Biovail, the Times’ Joe Nocera said, “[S]he had a handful of Gradient whistle-blowers asserting that the firm's analysts took notes about all the ‘dirt’ SAC had dug up on Biovail, and then repeated that dirt, word for word, in its reports. She noted that at the time Gradient was issuing a report that is at the center of the case, most Wall Street analysts were positive on the company. (Imagine that!) She swallowed whole the implausible notion that Gradient's reports were directly responsible for the drop in Biovail's stock price — never mind the company's earnings shortfalls and other problems.”
No doubt, Kynikos and SAC could both provide their own examples of short positions gone horribly awry – ones where bad information, bad analysis or a herd mentality made a portfolio manager think there were issues – and potential trading profits -- where none existed.
But because short-selling is a strategy with high risks, a sophisticated investor would not naively chase “bad” short positions, unless the investor had a death wish.
(In that vein, we’re reminded of the Feshbach brothers, who, after a successful string of “informational short positions” in the ‘80s and early ‘90s, fell prey to a sustained bull market. Last month, newly minted “Crisis Investor” Joe Feshbach declared, “There will, of course, be many market swoons to come and short selling may help mitigate losses during the toughest times. But for my and my investors’ money, the structural disadvantages of shorting make it too un-businesslike to pursue.”)
Despite the current wave of herd media attention, corporate management teams would be far better served by focusing their energies on building and enhancing their businesses and finances than worrying about a “shadowy world” of short sellers. Public company directors should be more concerned about making sure there is nothing about a company’s business or finances to give short-sellers ammunition, than about litigation against short-sellers after the fact.
-- Kirk Brewer, CEO, Core Communications Partners LLC
Technorati tag: Investor Relations
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