The Big Short (Interest) A Moneyball-Style Look At Short Interest by Adam T. Eagleston, CFA and David W. Wagner III – Opus Capital
- Within the small cap space, stocks with the highest short interest underperformed by a wide margin over the last five years.
- The effect is more pronounced in value, where companies with the highest short interest lagged the Russell 2000 Value by over 9% per year; excluding the speculative years of 2012 and 2013 doubled the level of underperformance to 18% per year, on average.
- Recently, we experienced an anomalous period (2/24/16 – 3/4/16) when the best performing stocks were those with the highest short interest.
- The top-ten performers during this time had an average short interest of 17%, and were typically energy companies with crushing debt loads and share prices of less than $1; the credit markets are predicting many of these names are bound for bankruptcy.
- While possible, it is unlikely for investors to win by owning heavily shorted names, and Opus typically avoids playing this losers’ game.
The Big Short (Interest) – A Moneyball-Style Look At Short Interest
The Oscars were presented a few weeks ago, and much to the chagrin of us investment types, the award for best picture did not go to The Big Short. The story of the contrarians who predicted the housing market collapse and how they turned those beliefs into billions by shorting various financial instruments is indelibly etched into the mind of every investor, becoming almost mythical in nature. However, the Academy deemed Spotlight, which features investigative reporters taking on a deep-rooted conspiracy, the best picture.
Much like investigative reporters, investors must also be diligent in separating fact from fiction, and avoid accepting as valid the myths that litter the collective mind of the market. As John F. Kennedy puts it, “The great enemy of truth is very often not the lie–deliberate, contrived and dishonest–but the myth–persistent, persuasive and unrealistic.”
One myth that we hear frequently, especially among value investors, is that high short interest presages future positive returns for a stock; in other words, the mythical short squeeze is real, and it happens often. Short interest is expressed as the percentage of shares that have been sold short, i.e., borrowed from an owner and sold at today’s price in hopes of covering at a lower price in the future, relative to the number of shares currently outstanding.
The reason these investors cite is that heavily shorted stocks have an inherent tailwind, given embedded demand from short sellers who might eventually need to cover their positions quickly. In this event, a stock’s price is driven higher because there is excess demand for a stock and a lack of supply. The value investor looking for the short squeeze is convinced his or her investment thesis for owning a heavily shorted stock will be proven correct. Once the market realizes this, the stock’s price will be pushed higher by the combined effect of positive news and the constricted supply of the stock. This represents a double whammy, so to speak, for the shorts.
Like our investigative reporter brethren, we want to diligently investigate matters for ourselves, and evaluate the effects of short interest on stock price performance. Does investing in stocks with a high short interest bring investors Joy, or is their experience more like that of Leonardo DiCaprio in The Revenant?
First, let’s look at what has happened historically. To begin our investigation, we grouped the constituents within the Russell 2000 (“R2K”), Russell 2000 Growth (“R2KG”) and the Russell 2000 Value (“R2KV”) into equally-weighted portfolios based on their short interest decile to see how each performed over a period of time; decile 1 contains stocks with the lowest short interest, while decile 10 has the highest short interest.
Looking back on how these stocks have performed over a five-year period ended 12/31/15 shows that stocks in higher short interest deciles performed poorly when compared to companies in the lower short interest deciles. This held true for the R2K, R2KG and R2KV, though was most pronounced among value stocks, where decile 10 names were involved in a Crash, coincidentally the title of the 2005 best picture.
This downward linear relationship shows that there may be something to poor performance being partially attributed to short interest. However, perhaps this is just hindsight bias, and stocks that have performed poorly see short interest escalate on their way lower.
To address this issue of hindsight bias, we look at the question another way, and delve into the realm of predictive analytics. Taking the previous results one step further, we again grouped the constituents within the R2K, R2KG and R2KV into equally-weighted portfolios based on short interest decile. Instead of looking back, we divided the universe into deciles based on short interest at a point in time (calendar year ends 2010-2014), looked at how they performed the following calendar year, then linked the calendar years to derive a cumulative five-year return (2011-2015).
This predictive analysis also demonstrated that the higher the short, the more difficult it is to outperform. These results indicate that short interest is a possible predictor of future performance across both value and growth stocks in the small cap space.
Taking a more granular look within the value universe is even more illustrative. The table below shows the relative performance within the R2KV for deciles nine and ten for the years 2011-2015. During speculative periods when low-quality dominated, e.g., 2012 and 2013, being in the most highly shorted names offered only a slight performance advantage, if any at all – a very surprising find. Conversely, when the market demonstrated meaningful volatility, the most heavily shorted names tended to underperform by wide margins, as we saw in 2011, 2014 and 2015. When times were not As Good As It Gets, decile 10 consistently plumbed the depths like the eponymous ship of 1997’s best picture winner, Titanic.
This performance begs the question – is short interest a factor that needs to be evaluated for predicting performance of a stock going forward?
At Opus, our mantra is invest with the wind at your back. This philosophy underpins the key tenets of the quantitative part of our investment process and is also an integral part of our qualitative analysis. While we do not make investment decisions solely on short interest, we are cognizant not only of the percentage of shorted shares, but also the direction in which a company’s short interest percentage is heading. Not only does Opus monitor short interest during our initial fundamental research, but we track short interest for each of the holdings in our portfolio. We tend to avoid stocks in the higher deciles of short interest, given that our nearly two decades of experience, as well as our research, have taught us that although highly shorted stocks can outperform, the odds are stacked against you.
Birdman (or the Unexpected Virtue of Ignorance)
In 2015, Birdman was the winner of best picture. Its full title appends the name of the title character with “or the Unexpected Virtue of Ignorance”. Ignorance of the deleterious effects