Life of an Activist Short Seller

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I didn't even know that there was such a thing as activist short selling. I just figured, hey, if I have something that's truthful, even if it's going to be controversial, why can't I publish it? And why can't I short it ahead of time as long as I disclose that I'm short?

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard, that's Carson Block. He's a rare sort of investor called an activist short seller. That means he bets against stocks and then publishes his reasons, which can persuade others, causing the share prices to fall. In a moment, we'll update listeners on the hydrogen truck maker Nikola, hear more from Carson about the life of an activist short seller, and run through the basics of how short selling works. What's a short squeeze? How about a hypothecation agreement? Ever hear of naked shorting? You will. I'll try to keep it clean. No promises. Listening in as always is our audio producer Meta. Hi Meta.

Hi Jack.

Let's start our short selling conversation with a quick update on Nikola, which makes hydrogen and electric big rig trucks and other vehicles. And when I say makes, I mean plans to one day produce but doesn't produce yet. We had its founder and CEO Trevor Milton on this podcast a few weeks ago. A short seller called Hindenburg Research had targeted the company with a report raising doubts about its hydrogen and electric truck technology. We told listeners to stay away from the stock until more is known. Nikola called Hindenburg's claims false and defamatory, but the shares nonetheless tanked. And Trevor Milton has now quit, saying he wants the focus to be on the company, not him. Separately, two women have now filed complaints with police alleging that they were sexually assaulted by Trevor Milton as teenagers more than 15 years ago, which he has denied through a spokesman. Remember the strategic partnership that General Motors had announced with Nikola, which sent its stock soaring? The date for finalizing the deal has come and gone, and GM now says only that it's still in discussions with Nikola. My thoughts on Nikola stock for long-term investors haven't changed. There's too much drama and not enough free cash flow, or any free cash flow, or even meaningful revenue likely for years. Watch it from a safe distance, but for now, don't get involved. Hindenburg is what you call an activist short seller. I think new investors sometimes find the idea of short selling in general confusing because as consumers, we would only ever sell things we already own, like a house or a car. But on Wall Street, it's possible to sell things you don't own and then buy those things later. If I sell a stock short at $30 a share, and it goes down to $20, I can buy it for less than I sold it for and pocket the difference. This is made possible by stock lending and something called a hypothecation agreement. When you open a brokerage account, there's typically a hypothecation agreement in the small print of the forms you sign that allows the firm to loan your shares to someone else, which is a lot less alarming than it sounds. Before an investor can sell a stock short, he or she must ask their broker if there are shares available for borrowing. The broker then contacts the firm's stock loan department, which is in touch with stock loan departments at other firms. If the shares are available, the firm charges a stock loan fee for them. The more difficult it is to find shares to borrow, the higher the stock loan fees, and those fees cut into potential profits for people who sell short. What if you somehow sell a stock short without borrowing it? That's called naked shorting, and it's not allowed for stocks. To be clear, there's plenty of permissible naked activity that happens on Wall Street. Options traders go naked all the time with tactics like the short naked put, the naked straddle, and the standing naked near your stove frying bacon. I was just testing you. That last one, it's not an option strategy. It's what I can only imagine is an exceptionally poorly thought-out cooking technique. Please don't fry bacon naked. Two last things about short selling. When you buy a stock, the most you can lose theoretically is everything, all the money you paid for the stock, because the stock could go to zero. But when you short a stock, your losses are theoretically unlimited because there's no limit to how high stocks can rise., and that makes short selling risky. If you're not sure whether it's for you, it's not for you. Now, because short selling is risky, investors who do it typically have to have plenty of cash or securities on deposit so their brokers won't get stuck with the losses. If you short a stock and it goes up, you begin developing paper losses, and your broker might eventually want you to send more money. When a heavily shorted stock goes up and a lot of short sellers rush to buy it to keep their losses from growing, it can turn into panic buying and send the stock sharply higher. That's a short squeeze. And that's enough for now about regular short selling. I mean, there's more to know. The Dukes are trying to corner the market.

They know something. I can feel it.

Let's get in on it. We could talk about how Eddie Murphy and Dan Aykroyd teamed up to turn the tables on the Duke brothers by shorting orange juice futures in the 1983 movie Trading Places. How can the price be going down?

Something's wrong.

Where's Wilson? But guess we'll save that for another episode. Let's move on to activist short sellers who open short positions and then publicize their criticism of the companies they target. Social media has given activists new levers to pull. To learn more, I reached out to one such activist. Hi, Carson. Hi, it's Jack Howe from Barron's.

How are you?

Well, how are you doing? I don't talk a lot to short sellers.

Nobody does.

We're mostly dead. Carson Block is the founder of Muddy Waters Research. There was a blues singer from Mississippi who was big in the 1950s and went by the name Muddy Waters. There's also an English rock band that supposedly came up with its name in the early 1960s when one of the band members saw a Muddy Waters record on the floor with a song called "Rolling Stone." But Muddy Waters Research isn't named for blues or rock and roll. It takes its name from a Chinese proverb which says, "Muddy waters make it easy to catch fish." Carson has long specialized in selling short Chinese stocks. He says he used to work with his father, who was a stock analyst, and an optimist by nature who looked for the best in people. They were covering tiny companies called microcaps. This was during the dot-com stock bubble of the late 1990s. Carson says he and his father got blown up and lost some of their own money and were embarrassed in front of their institutional clients because company managers they had met with had been lying to them.

So it was a really embittering time for me. I just felt like there were so many predators, especially among managers, company managers out there. So I chose to go to law school with this vague notion that I would learn how to better protect myself against those guys.

By the way, I know it might sound like Carson is electronically disguising his voice to add intrigue, but he's not. We just had a lousy phone connection when we spoke. Anyhow, He went to law school, practiced with a U.S. law firm in China, started a business there, and eventually his father got him interested in Chinese companies that were securing stock listings in the U.S. through what are called reverse mergers. Carson started looking into a company called Orient Paper, and he disagreed with the company's financial reporting and published his allegations in a report. This was 2010. Carson bet against the stock by buying a type of options contract called a put.

I didn't even have the money to short stock. I bought $2,000 in puts, and that was effectively, you know, somehow or another probably financed by a credit card that I had, and sent it out to maybe 50 people I'd last spoken to in the markets in '01, '02. And within 24 hours, the stock was down 55%.

I should note that Orient Paper hired outside auditors who looked into its finances and didn't find evidence to support the Muddy Waters report. The company later changed its name to IT Tech Packaging. The stock has been a terrible performer over the past decade. But Carson, after that first trade, was off and running.

Prior to this, I didn't even know that there was such a thing as activist short selling. I just figured Hey, if I have something that's truthful, even if it's going to be controversial, why can't I publish it? And why can't I short it ahead of time as long as I disclose that I'm short? And no securities lawyer could give me a good explanation as to why I couldn't do those things, even though they advised me not to do it just because it wasn't done.

Carson eventually expanded his search for wrongdoing outside of China.

I decided that I could do this globally. Global capital markets, I mean, the reality is they attract the wrong elements. I mean, smart criminals will go to capital markets. Dumb criminals will hold up liquor stores. And then you have this class that's in between that operates in this gray area, which is company managements that do everything that's just on the right side of the letter of the law, but definitely violates the spirit of the law.

Carson says he looks for companies that are frauds. Not in a legal sense, but in the sense that they violate the spirit of the law, which he views as fraudulent. Unlike a fundamental short seller, Carson doesn't wait for investors to, as he says, "puke the stock" on their own. You might say he induces vomiting by publishing reports. He had a major success this year with Luckin Coffee, billed as a company that could one day become the Starbucks of China, It was valued on the NASDAQ at $12 billion in January. Then an anonymous email went around to short sellers alleging that Luckin had inflated its sales. Carson published the report on Twitter. The company denied it at first, then later said that hundreds of millions of dollars of sales had been faked. The stock price collapsed, and the company said in June it would be delisted by NASDAQ. Carson doesn't publish his returns. He says they've been very high relative to other funds, as he puts it. He says this year's returns are positive but embarrassing despite the success with Luckin Coffee. He says it's the toughest year he's had as a short seller. One last question: I asked Carson what people who know him would say about his personality. I was wondering if he defied the stereotype of short sellers as negative people. His answer started off normal, then got maybe just a bit heavy.

I like to think that I make skepticism fun, in that I have a really wicked biting sense of humor that can kind of put a rainbow on top of everything that sucks when I talk about it.

Okay, so far so good. Then he said a friend asked him if he was excited about the details of a new business line they were thinking about, He wasn't.

And I said, "Ed, I don't think I get excited about anything anymore other than when something is falling apart." Like, I just don't feel like excitement is an emotion that I feel anymore. So it doesn't mean I don't enjoy things. I do. And certainly schadenfreude is, you know, the most intense feeling that I get from my work.

Schadenfreude. That's a German word meaning pleasure derived from someone else's misfortune. You were saying, Carson?

I just don't encounter things in life right now that make me say, "Oh, wow, this is like new and awesome." So, yeah, I mean, look, that's probably a function of personality and spending too much time trawling the sewers of the world's financial system, but hopefully my friends will also say that I'm loyal and I never BS them. I like to think that's true.

Thank you for your candor, Carson, and I hope you find something bad that falls apart in a way that gives you double schadenfreude. Let's finish our short selling discussion with a word on regulation. There are efforts underway to put some new rules around activist short selling. A paper from Columbia Law School called Short and Distort describes more than 1,700 short seller attacks between the years 2010 and 2017 where the sellers published reports using fictitious names. The paper finds that a lot of the stocks involved sold off and then rebounded, suggesting that the short sellers' claims weren't widely accepted, but that there was ample opportunity to make money on the short selling just the same. I spoke with Columbia Law professor John Coffey. He describes Muddy Waters' research as the Tiffany of short sellers, as in the famous jeweler. Professor Coffey also says that in general, companies are at a big disadvantage to short sellers.

Remember that public companies are generally going to be in a disadvantaged position from the standpoint of libel and defamation suits.

Professor Coffey mentions something called the Communications Decency Act and how publishing platforms have special protections and why a First Amendment standard set in a case called New York Times v. Sullivan makes it difficult to win U.S. defamation suits.

You're going to have to prove that this was intentionally reckless, that they were indifferent to the truth or accuracy of their statements.

Professor Coffey says short-term trading by some short sellers is a problem.

If you are a short seller who can write a vivid statement that something is rotten in the state of Denmark, that something is really phony at this company, it will cause a market decline. And if you're willing to close out your position before the company comes back with its rebuttal, you can make some profit.

By the way, the phrase "something is rotten in the state of Denmark" comes from Hamlet, a play written more than 400 years ago. Today, Denmark is a happy place filled with fine people and nothing rotten, right, Meta?

That's right.

You're thinking of Sweden.

Oh no.

We love our Swedish listeners.

We do.

We do.

I'm just kidding. Anyhow, Professor Coffey says he would like the Securities and Exchange Commission to take a case or two against reckless short sellers, but that the SEC is likely nervous over First Amendment issues. Meantime, a group including Professor Coffey has petitioned the SEC saying it should require short sellers to announce when they buy back the stock to close their positions. Metta, how about a listener question? What do you have there? Something with some pizzazz, a little razzle-dazzle. I'll give you razzle-dazzle. We've got a great question from Anna, who lives in Baltimore, Maryland.

Let's hear it. Hi, Jack and Metta. I'm a big fan of the podcast. My question is on value investing. I have exposure in my portfolio to both value and growth funds, but I'm considering increasing my exposure to value. To be more neutral weighted into an economic setting that could go multiple ways from here. How are you thinking about a potential regime shift back to value? And if COVID is still present in the next few years, do you expect the discrepancies between value and growth to persist? Thanks for answering.

Thank you for your question, Anna from Baltimore. Let's nail down what we mean by value stocks and growth stocks. Value stocks trade cheaply relative to some fundamental measure of a company's economic output or worth, like its earnings, its sales, or the accounting value of its assets net of its debt. That's called its book value. These companies usually trade cheaply because of one or more perceived flaws. Growth stocks, on the other hand, tend to be expensive relative to those same measures. Investors are willing to pay up for growth stocks because they expect these companies to quickly gain new business thereby growing into their lofty valuations. Now, those definitions are not airtight, and a stock's status can change. Microsoft was a growth stock in the 1990s, back when it dominated personal computer software. Then that business fell out of favor, and it became a value stock in the early 2010s. Since then, it has successfully pulled off a transition to cloud computing, and the stock looks like a growth stock once again. Okay, so there's a decades-long body of research documenting something called the value effect, the tendency of value stocks to outperform growth stocks. And there's always been disagreement about why the value effect exists. Some people say it's because value stocks come attached to flawed companies, which makes them riskier than other stocks, and that the extra return compensates investors for that risk. And some people say investors just tend to exaggerate everything in their thinking. They overestimate the growth potential of thriving companies and they underestimate the ability of struggling companies to turn things around. Either way, what's clear is that the value effect has been mostly absent for more than a decade. Growth stocks have trounced value stocks. And the S&P 500 index, which weights companies according to their stock market values, has arguably become a growth-tilted index led by Microsoft, Apple, Amazon, Alphabet, and Facebook. The longer that happens, the cheaper value stocks become relative to growth stocks, and the wider the valuation gap between the two, the more certain some investors become that the triumphant return of the value effect is right around the corner. But it hasn't happened. And when I get something wrong, I try not to stay wrong forever. So I've stopped predicting a comeback for value, but that doesn't mean it will never happen. Just this past week, strategists at BofA Global Research, part of Bank of America, pointed out that although the Russell 1000 Growth Index outperformed the Russell 1000 Value Index by 6 percentage points in August, the value index has actually outperformed by 4 percentage points in September. They offer a long list of reasons they think value has more room to run. For example, we're hopefully coming out of a recession, and value has led growth coming out of the past 14 recessions. So if B of A is right, Anna, then yes, you should shift some money into value funds. My only hesitance is that I suspect this epic outperformance we've seen for growth stocks is related to our long experiment with keeping interest rates near zero, and it's difficult for me to imagine the Federal Reserve raising interest rates over the next few years. But that's just one factor among many to consider, and if the overall stock market as reflected by the S&P 500 index has taken on a growth tilt,, then a position in a value fund might help balance that out. One last point on the subject: for folks who plan to search for individual value stocks, B of A recommends looking for ones that also have high returns on equity. In other words, companies that earn a lot of money relative to the net value of their assets. That's to focus on quality companies and avoid ones that are called value traps. Stocks that look cheap but that aren't worth buying even at deep discounts. The strategist recently highlighted AT&T, Goldman Sachs, and Alaska Airlines, among others, as quality value picks, but it called companies like Molson Coors and KeyCorp potential value traps. I don't want you to take that personally, Molson Coors. You're doing important work. Yep. Thank you, Anna, for sending in your question. And everyone, please keep the questions coming. Just tape on your phone using the voice memo app and send it to jack.how@barons.com. Thank you for listening. Meta Lutzow is our producer.

She loves Sweden.

I sure do. Subscribe to the podcast at Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @JackHough, H-O-U-G-H.

See you next week. At CLA, we're in your corner and on it. We coach tax strategies and Little League first base. We help you adopt AI data data tools, and we adopt rescues named Buddy. We walk your factory floor and jog the local 5K, though sometimes we walk that too. Wherever you're coming from, we're right there with you. Wherever you're going, we'll get you there. CLA—CPAs, Consultants, and Advisors.

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