Beneish On Equity Overvaluation and Short Selling

We use detailed security lending data to examine the relation between short sale constraints and equity overvaluation. We find that stocks’ “special” status exhibits a non?linear (U?shaped) relation with their short interest ratio (SIR), and that a stock’s special status, rather than its SIR, predicts negative returns. We show that short?sellers trade on a variety of firm characteristics and against high sentiment. Specifically, we find: (1) the abnormal returns to the short?side of nine market ‘anomalies’ identified in prior work are attributable to special stocks; and (2) future negative returns to special stocks are directly related to the lendable inventory in each stock rather than to its shares borrowed. Overall, our results suggest returns to the short side of documented ‘anomalies’ may not be obtainable without significant cost, and that the supply (available inventory) of lendable shares is the primary binding constraint to informational arbitrage in the case of equity overvaluation.

In short supply: Equity Overvaluation and Short?Selling

 

1. Introduction

 

 

The informational efficiency of stock markets has been a central theme in financial economic research in the past 50 years. Over this period, the focus of academic research has gradually shifted from the general to the more specific. While earlier studies tended to view the matter as a yes/no debate, many recent studies now acknowledge the impossibility of fully efficient markets, and have focused instead on analyses of factors that could materially affect the timely incorporation of information into prices. At the same time, increasing attention is being paid to regulatory and market design issues that could either impede or enhance pricing efficiency.

 

One aspect of equity market pricing that has received increasing academic attention is the role played by short sellers. Prior studies have consistently demonstrated that, as a group, short?sellers are sophisticated investors (e.g., Drake et al 2011). At the intraday level, short?sale flows improve the informational efficiency of intraday prices (Boehmer and Wu 2012). Globally, the introduction of short? selling in international markets is associated with a lowering of country?level costs?of?capital, an increase in market liquidity, and an improvement in overall pricing efficiency (Daouk et al. 2006; Bris et al. 2007). At the same time, even temporary short?selling bans can impede pricing efficiency for the equity options in the banned stocks (Battalio and Schultz 2011). In short, the evidence from prior studies consistently shows that short?sellers are key market intermediaries, whose actions help to incorporate a variety of information into equity prices.

 

What is less understood in the literature are the sources of the short?sellers’ insights, the nature of the constraints they face, and the extent to which other market participants can benefit by mimicking their actions. On these issues, a number of puzzling regularities remain. For example, prior studies show that firms with higher (lower) “short sale ratios” consistently earn lower (higher) returns in subsequent

months, well after this information is publicly available. The ‘bears’ have left some scraps on the table, either because they face constraints or because short sellers (and the investors imitating them) underutilize publicly available information.

 

In this paper, we ask (1) What prevents short sellers and other market participants from fully eliminating the observed negative association between short interest and future returns?, and (2) To what extent are the negative returns to the short?leg of other market pricing anomalies due to frictions in the market for short?selling? We show that the supply of lendable shares is crucial in answering these questions. The total supply of lendable shares affects the size and volume of short positions that can be taken at low cost. When the supply of shares available for lending is a binding constraint, the extent to which the negative views of sellers can be impounded into price will be limited.

 

The primary variable used in prior studies to measure short?sale intensity, the “short?interest ratio” (SIR, defined as the ratio of total shares shorted to total shares outstanding), tends to mask the true importance of supply. The total shares shorted in the numerator is an equilibrium result that reflects both supply and demand. Thus, a firm’s open short interest may be low either because (1) few investors have negative views, or (2) the supply of lendable shares is limited. The concerns with SIR are amplified by a denominator that implicitly assumes all outstanding shares are equally easy to borrow. However, the supply of lendable shares is often less than 100 percent of shares outstanding for a variety of reasons.¹ Indeed, our data show that stocks that are difficult to borrow have, on average, less than 10 percent of their outstanding shares in the form of lendable supply that is relatively easy to locate and borrow. Further, even for easy?to?borrow stocks the average number of easily lendable shares is typically only 20 percent of shares outstanding. In other words, a SIR of 10 percent could represent a

 

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