Returns in short supply

It’s been a torrid time for short-sellers of Elon Musk’s Tesla as the company has beaten expectations on profits. Does it challenge the concept of short-selling?

• Short-sellers have lost over $8bn in Tesla for the year to date
• Short-sellers are battling uphill, with costs for shorting and the       impact of dividends a drag on potential returns
• Nevertheless, short-sellers have a place in price discovery

This week saw short-sellers of Tesla lose $2.5bn in a single day after the company’s fourth-quarter results beat expectations. This brings their loss for the year to date to $8.31bn (source: S3 partners) and appears to highlight the key problem of short-selling – the market can stay irrational far longer than you can stay solvent.

Tesla is an extreme example and polarises opinion. There are clever managers on both sides of the debate: on the one hand, James Clunie, manager of the Jupiter Absolute Return fund, has been a long-term bear, believing that the company’s debt pile and low profitability make it one to be avoided. On the other are managers such as James Anderson at Baillie Gifford, who – while accepting Elon Musk’s limitations – believes the investment potential of the company’s transformative technology will eventually be realised.

There is a philosophical issue at stake here. Short-sellers are always battling uphill. Not only does it cost to short the stock, but the impact of dividends also acts as a drag on potential returns. Even before this recent and unusually lengthy bull market, stock markets have tended to go up over time. In the technology sector, there is the even bigger hurdle that investors tend to be irrationally enthusiastic about new technologies and may pay only scant attention to a company’s fundamentals.

So why do it? In many ways, it seems a thankless specialism. Shorts have an unlimited downside and only limited upside – a short can only fall to zero. Equally, they are always subject to the unexpected event – Porsche’s bid for unloved Volkswagen in 2008 remains the most famous, but even really bad companies can occasionally find a buyer.

That said, short-selling can fulfil an important role in price discovery, ensuring that stocks ultimately find their fair value. It also presents an important option for investors in weaker markets, doing well when everything else does badly. As such, they are an option for those who would rather mitigate volatility, while accepting that there will be periods when they act as a drag on the wider performance of a portfolio.

Short-selling has some seductive appeal, allowing investors to make money from failing businesses and holding those failing businesses to account. However, it is a complex business. Investors need to go in with their eyes open.

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This article was sourced from Adviser-Hub.co.uk.