How to react when holdings are shorted by famous institutions?

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The origin of this article

A letter from a reader said: What should an investor do if his holdings are attacked by a short seller? How would you do it? This question will be asked, naturally it is Block’s case.

What the hell happened?

The Block case

As the investment institution The Hindenburg (The Hindenburg) issued a short report on March 23, 2023, it accused Block (ticker: SQ) of having a problem with its business model. The Hindenburg Research report cites former Block employees as saying that more than 40 percent of the Cash App accounts they reviewed were fake accounts, involved fraud, or were controlled by a single individual with multiple accounts. I suspect the company is fraudulent, and I don’t believe the number of users announced by Block, so I suggest investors to short Block.

Who is Hindenburg?

Hindenburg has become famous for the following two major achievements in recent years:

  • A report released on September 10, 2020 pointed out that Milton, the co-founder and CEO of Nikola (ticker: NKLA), was suspected of exaggerating the test results of the company’s electric trucks and defrauding the content of the test videos. Subsequently, Nikola’s stock market plummeted, and founder Trevor Milton announced his resignation from the board of directors.
  • Hindenburg became famous because on January 24, 2023, it released a short-selling report of Ani Group, the richest man in India, which caused heavy losses in the stock price of Ani Group. The report accused Adani Group of gaining wealth through illegal means such as stock market manipulation and accounting fraud. It has defrauded 100 billion U.S. dollars in the past three years alone. The stock prices of major companies under India’s richest man, Gautam Adani, plummeted. In two days, the market value of Gautam Adani evaporated 51 billion U.S. dollars and assets shrank sharply. Adani’s wealth ranking also fell out of the top 5 in the world in one day.

Why do people believe in Hindenburg?

The 15 shorting reports issued by Hindenburg since 2016 were later proved to be true. This is why Hindenburg’s report on Block’s shorting this time will cause investors to panic, causing Block’s stock price to plummet.

The consequence

Block’s stock price closed down 14.8% that day, losing all gains since 2023, and even fell more than 21% intraday.

The response from Block

Block said he was considering filing a lawsuit against Hindenburg over his false allegations and said the company would work closely with the SEC to take any necessary steps. However, Wall Street believes that Block’s response is too weak, and further and stronger actions should be taken to protect the rights and interests of investors.

On March 30, 2023, Block further countered Hindenburg’s short-selling report: saying that Block’s monthly active user (MAU) statistical method is “more conservative” than other companies. About 44 million of Cash’s 51 million active users are associated with verified users on the platform. 97% of the funds flowing into the app in December 2022 came from these verified accounts. Authentication is required as customers use Cash App’s services more or more frequently, and the process includes verifying the user’s full name, date of birth, address, and social security number.

This counterattack response report was subsequently recognized by most professional analysts on Wall Street, so Block’s stock price also recovered most of the lost ground after being shorted by Hindenburg.

Wall Street’s view on Block case

Mainstream opinion

The mainstream opinion of Wall Street peers on Hindenburg’s short report is: “It has no value, because the content is unprofessional and the evidence is weak.”

Analyst’s immediate response

Many analysts suggested that clients should take the opportunity to buy on dips while Block’s stock price fell sharply. Some analysts even raised their ratings on the stock due to the undervaluation caused by the sharp drop in the stock price.

Why Iinstitutions are shorting?

There are almost no exceptions. Most of the institutional investors enter the market to sell short before releasing the short report, and then publish the short report, so that they can make a large profit after covering in a short period of time!

Impact on listed companies

Share price usually plummets

The stock prices of shorted companies will collapse at the beginning, because most investors will panic and follow up to liquidate their holdings. This is a typical herd mentality.

As far as corporate stocks are shorted, the shorted companies are in an unfavorable situation with unequal weapons. Because most investors will think that there are no waves without wind, and it is useless for companies to explain in the first place; they can only let time prove their innocence.

Previous notable cases

Alibaba

In the first two years Alibaba (ticker: BABA ) was listed on the US stock market, many non-mainstream analysts on Wall Street continued to issue reports, publishing various short-selling suggestions that were not conducive to Alibaba. There are many reasons why Alibaba is a Chinese company or its corporate governance is opaque. With Alibaba’s super market value and revenue scale, it is not believed that Alibaba can have a quarterly revenue growth rate of up to 40%, or it is suspected that Alibaba’s financial reports are fraudulent. But these remarks have almost disappeared two years after Alibaba went public. Why? Because it’s all based on biased assumptions or inferences. No convincing evidence was presented.

Shopify

Another famous case is Shopify (ticker: SHOP), an independent website e-commerce company that has repeatedly make of Wall Street’s jaw drop​​ after its listing. I mentioned this case in section 7-2 of the book “The Rules of 10 Baggers“, pages 364-365.

The most representative short-selling report is the report released by Citron on October 6, 2017, accusing Shopify of inaccurate financial reports and data, and also conclusively stating that the FTC will impose on Shopify’s suspected pyramid scheme-like business model and will conduct an investigation. The company’s shares closed down 11.6 percent on the report. Citron’s main argument is that in just ten months, Shopify’s stock price tripled that year, so it is inferred that there is a fraud.

Citron is a well-known short-selling institution in the US stock market, and because of the Shopify short-selling report case, it has screwed up. Later, it shorted other U.S. stock companies one after another, but with little success. Afterwards, Citron simply announced to close the shorting business in January 2021, ending 20 years of short-selling research, and will focus on long-term investment; it will no longer carry out short-selling operations, and the company will only go long in the future.

The result of shorting

Both Alibaba and Shopify are US-listed companies with large market capitalization (Alibaba’s listing was the largest listing in US stock history at that time), and they are not small and medium-sized listed companies that have just been listed for a few days or months. I cite these two examples because they are very famous cases. The short-selling reports of the above two well-known companies, after a few months, the stock prices have returned to the level before being shorted, and even exceeded the previous stock price level.

How reliable is it?

Some tips

Especially for companies with super large market capitalization, or companies with a long history of listing, they have been through countless times, plus many years, various tests and doubts from all parties, the chance of fraud is low.

But here I want to emphasize again that the only certainty in the stock market is the uncertainty of the stock market. There is no such thing as 100% in the stock market, and it is still possible for super-large companies to fake; it is not impossible. The Enron scandal at the beginning of this century is a famous case. Before the scandal broke out, Enron was the darling of Wall Street and a blue-chip stock favored by retail investors. Many people invested their lifetime retirement funds in the company’s stocks. But when the scandal first broke, most people didn’t believe it; the result was that investors lost their money.

Commonality of shorted targets

Generally speaking, for listed companies listed on the over-the-counter market (OTC), or for small and medium-sized listed companies with a small market capitalization, the probability of financial reporting errors, or fraud, and various scandals is really high. Therefore, there are also some professional short-selling institutions in the U.S. stocks that will target these stocks, believing that the stocks may eventually be delisted, so that they can achieve 100% return on investment without buying back.

But the problem is that short sellers seldom touch them in order to win media space. Of course, the stock price of this kind of stock is usually already very low, and the limited space for short-selling to make a profit is another reason why short-selling institutions do not want to touch it.

Short-selling institutions have a characteristic, they usually look for well-known or popular companies; generally speaking, they will target companies that were not well-known in the past but have recently risen. Because this will attract attention, catch people eyes, bring customers to the company, have the benefits from shorting, and generate revenue from customer commissions and fees.

Shoot at random? or no-based?

the answer is negative. My personal opinion is that short-selling institutions are more attentive than ordinary investors. I have reminded investors in my book and blog post (see “Why shorting is extremely dangerous to retail investors?” and”Don’t borrow money, shorting, or derivative products“) that shorting requires professional skills,market acumen and quick response are beyond the capabilities of ordinary investors or small investment institutions. Most short-selling reports require a lot of effort, mobilizing considerable time and human resources to produce a reliable short-selling report.

Chinese stocks

The fraud probability of Chinese stocks is higer

Pay special attention, because many past facts have proved that many Chinese concept stocks that have been shorted by famous institutions are indeed well-founded; such as Luckin Coffee (ticker: LKNCY). Muddy Waters, a well-known short-selling institution, once shorted some of the Chinese stocks. Of course, some of them were no-based, but many of them, as Muddy Waters’ report said, the consequence was delisted.

Numbers speak

Here we cite several well-known short-selling institutions to report the results of the short-selling of Chinese stocks for your reference:

  • After announcing in January 2021 that it would no longer carry out shorting, as many as 7 of the more than 20 Chinese companies that Citron previously attacked were forced to delist! This is an astonishing ratio.
  • From its establishment in 2010 to May 2020, Muddy Waters has shorted 18 Chinese companies, including the most famous Luckin Coffee. Of the 18 companies that were shorted, 9 companies are still trading normally, 1 company has been suspended, and 8 companies have been delisted (including being acquired or returning to A shares). How high the ratio is, you can calculate!

No need to buy Chinese stocks

I mentioned my views and reasons for the stocks of Chinese companies listed in the United States on page 227 of “The Rules of Super Growth Stocks Investing” 3-6. For ordinary investors, unless you have “very special” reasons, You don’t have to buy stocks of Chinese companies listed in the United States. There are nearly 12,000 companies in the U.S. stock market that can be traded and considered. It is not necessary to buy the stocks of Chinese companies listed in the U.S.

Advice to investors

Focus on the companies you invest in

Investors still need to go back to the real performance of individual companies; carefully study the company’s financial reports, pay attention to the company’s dynamics, attend financial report conferences, and carefully read relevant reports issued by reputable analysts or well-known market research companies. Because the reports of reputable analysts or market research companies with credibility have a certain degree of credibility (again, there is no such thing as 100%). And they are usually released after spending time and manpower conducting on-the-spot investigations on a regular and continuous basis. Please pay attention to the three words continuous. If the operating figures provided by them are not far from those provided by listed companies, it means that listed companies can be trusted.

From the comparison of these actual data, it is clear at a glance whether the report of the short-selling agency is true. Financial reports with legal force are credible, and it is not impossible to falsify, and the probability of falsification is very low; because it must be reported to the SEC for filing.

Those who can’t afford it, invest in ETFs

Investors don’t dance with it; you have to be able to judge who is right and who is wrong. If you see this sentence, you don’t agree with it, and your reflexive response is: I have no ability to judge! Then I can only advise you, don’t touch individual stocks, and don’t do active investing by choosing stocks by yourself; investing in the ETFs tracking major market indexes will be your better choice.

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credit: investopedia.com

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