What is short selling?

It is self-explanatory how profits are made from a rising share price, but how can we profit if we expect the price to fall? At Watermark we look to take advantage of both opportunities.

We can borrow the shares of companies we expect to perform poorly from other institutional investors, for a fee. We then sell these shares on market, collecting the sale proceeds. Selling shares that have been borrowed is called short selling. If we are successful and the price falls, we can then re-purchase the shares and return them to the beneficial owner profiting to the extent the value of the shares have fallen.

A simple example:

Investor ‘A’ expects the price of ABC Limited shares trading at $1/share to fall and the price of XYZ Limited shares also trading $1/share to rise.

He borrows 100 shares from investor ‘B’ a long term holder, for a small fee. He immediately sells those shares, raising $100 in cash. If the price falls to 75c as expected, investor ‘A’ can then re-purchase the shares for $75. He would return the shares to the beneficial owner ‘B’ and keep the difference of $25.

This is only one side of the transaction however. Short selling is often misunderstood because investors fail to consider the investment of the short sale proceeds. Looking at a short sale in isolation is akin to looking at the cost of a loan without also considering the reinvestment of the loan proceeds. ‘Shorts’ are first and foremost a source of additional funds for an investor, so we also need to consider the purpose of raising the funds.

As with any investment proposal we need to consider both the return on investment which is funded by the short proceeds and the cost of funding that investment via the short sale.

The cash proceeds from short sales can be either retained in cash or reinvested in other assets, the outcome is very different:

I. When the short proceeds are reinvested in other risky assets leverage is introduced into the structure with the investor benefiting from any outperformance of the asset over the liability (short).

II. If the proceeds are retained in cash, the investor will benefit to the extent the liability falls in value. If this position is held in a share portfolio, the short becomes a hedge for the fund’s other share investments.

Returning to our example above:

If the short proceeds from selling the ABC shares were retained in cash then ‘A’ would also earn interest on the $100 deposited. At 5% the overall profit on the transaction increases to $30.

Alternatively, if investor ‘A’ were to reinvest the short proceeds in 100 XYZ Limited shares which he expects to increase in value, he would do even better. If the shares rise to his target price of $1.25/share, he can then sell the XYZ shares for $125, buy back and return the ABC Ltd shares that he borrowed for $75 and pocket the difference of $50.

In this example the investor has profited from both sides of the transaction. Of course it can go the other way as well. A less successful investor may lose on both sides of the transaction.

In long/short investing, it does not matter whether the value of shares that have been sold short increase or fall in value, the investor is always ahead so long as the short proceeds are invested in an asset (or retained in cash) that outperforms the shares that have been sold short.

Investors benefit from long/short investing in three ways:

I. They access a further source of alpha in mispriced shorts.

II. They leverage their exposure to the stock picker without concentration risk.

III. They benefit from the natural hedge in the structure.

This allows the manager to take full advantage of mispricing opportunities across the value spectrum while retaining less market risk.

In summary

When an investor borrows shares to sell- or ‘short sells’- the borrowed shares are a liability on the investor’s balance sheet. When these borrowed shares are sold, the cash proceeds become a matching asset on the investor’s balance sheet. The investor will choose either to retain these funds in cash or reinvest the funds in other shares depending on the opportunities available.

As with most liabilities, shorts are a source of additional funds for the investor. Shorts are an attractive means of funding an investment in shares because of the hedge. i.e the asset and liability are both shares and will move up and down together in response to exogenous forces.

If the short proceeds are reinvested in additional shares, the fund is more leveraged to the success of the stock picker. The leverage is unlike financial leverage however given the natural hedge in the structure. Alternatively if the funds are retained in cash, the shorts become a hedge for the fund’s other share investments.