Noble Group Limited and the Short Sellers: My Thoughts – Part 2

Is Singapore’s stock market turning into a play-ground for short sellers? That’s a worry that some investors have in their minds, judging by a reader-penned letter titled “Don’t let S’pore be playground for short-sellers” that was published in The Straits Times yesterday morning.

The letter cited commodities trader Noble Group Limited (SGX: N21), whose “share price has fallen by 40 per cent since being attacked by Iceberg Research in February,” as an example of the damage that short sellers can inflict on the stock market.

There are plenty of talking points in the letter worth discussing, so for the sake of brevity, I’d be breaking up my discussion into two articles.

In the first article, I discussed how those who think Noble’s the poster child for all that’s wrong about short sellers are missing an important point that Noble itself may have a big role to play in its painful price decline.

In this article, I’d like to discuss the role of short sellers and why they should not be categorically vilified.

The precious role of shorts

Short sellers are often hated by market participants and for a good reason. Most investors are long on stocks, meaning they’re betting that stocks would be rising over the long-term. Short sellers however, are on the opposite end of the trade: They’re betting that stocks would fall.

There can be many ways that short sellers go about selecting their investing opportunities.

Some try to spread malicious – and false ­– rumours about a company, hoping to illicit panic and then making a quick buck in the process; they’re a distasteful bunch of people. Meanwhile, there are some who pick only companies that are either severely over-valued in relation to their business prospects, have broken businesses, or have simply been doing something wrong.

It’s in this distinction that short sellers should not be painted with a broad brush as entities which solely cause pain and confusion in the stock market. In fact, the latter group are actually acting as much-needed policemen of some sorts in the financial markets.

Shorting with morals

David Einhorn, a highly successful and sharp hedge fund manager is a great example of the latter category.

In 2002, he made a public presentation of his short thesis in the prestigious annual Ira Sohn charity investing conference on Allied Capital, a firm that provides financing for small businesses. Einhorn believed that Allied Capital had serious accounting issues and were vastly overstating the value of its illiquid securities.

Allied Capital started slinging mud at Einhorn, resulting in the Security Exchange Commissions (SEC), the regulator of the financial markets in the U.S., launching an investigation on him.

After five long years, Einhorn was finally vindicated. In 2007, the SEC found Allied Capital to have broken securities laws on the way it had valued some of its investments. Then in 2008, one of Allied Capital’s portfolio investments went bankrupt. Allied Capital eventually sold itself to another financial firm at a price that’s nearly 90% lower than its peak in 2007.

Einhorn had documented most of his long fight with Allied Capital in his enthralling book Fooling Some of the People All of the Time. While Allied Capital and its investors wouldn’t have been happy to have Einhorn breathing down their necks, the truth was that the firm did have some serious issues, and investors who had listened closely to what Einhorn had to say may have been able to escape before things became deadly serious.

In 2008, in the midst of the storm during the Great Financial Crisis, Einhorn disclosed another high profile short and walked through its investment thesis in the same charity investment conference in which he first publicly revealed his Allied Capital bet. This time the target was Lehman Brothers, and aggressive accounting practices at the investment bank was also part of Einhorn’s short assault.

Investors who followed Einhorn’s public presentations on the bank may have been able to spot the problems and stepped out of harm’s way before Lehman had to file for bankruptcy a few months after Einhorn’s incendiary presentation at Ira Sohn.

How to win the shorts

But Einhorn’s not always successful in short selling. In late 2012, he went after high-flying Mexican fast-casual restaurant operator Chipotle Mexican Grill. This time, Chipotle wasn’t guilty of any wrongdoings, but Einhorn thought the stock was overvalued and that Chipotle’s business itself was losing lustre in the face of competition from other similar restaurant concepts.

Chipotle was listed in 2006 and up to 2012, had been a phenomenally successful business. You can see these in the chart below:

Chipotle Mexican Grill's growth in revenue, profit, and operating cashflow - 2006 to 2012

Source: S&P Capital IQ

On 1 October 2012, the day prior to Einhorn’s recommendation to short Chipotle at an investing conference, the Mexican restaurant’s shares were trading at US$316. At its bottom after Einhorn’s presentation, Chipotle’s shares were down by a quarter after falling to US$238.

But today, Chipotle’s trading at more than US$658 apiece. Turns out, the company had continued to churn out the same phenomenal growth that it had done from 2006 to 2012 (see table below) and that great business performance had carried the company’s shares onto new heights.

Chipotle Mexican Grill's growth in revenue, profit, and operating cashflow - 2006 to 2014

Source: S&P Capital IQ

Chipotle’s experience is a fantastic example on how a compnay can triumph over the shorts: By focusing on its business and running it well.

A Fool’s take

Short sellers who spread false rumours about a company are certainly a nefarious influence in the stock market and they ought to be controlled. But, this does not mean that investors have to fear all short sellers or be hostile toward them in a categorical fashion. As we’ve seen with David Einhorn and some of his successful shorts, short sellers can act as useful canaries in a coal mine for other investors too.

Coming back to Noble, I mentioned in the first article in this series that the company has recently commissioned a third-party review of certain aspects of its business that’s been heavily criticised by short sellers. We’d have a clearer picture on just how right or wrong the short sellers are when the findings of the review are released.

In the meantime, Noble could perhaps pick up a trick or two from Chipotle’s book and improve its business results – that’s the best way a company can win against short sellers. As it stands though, Noble has a hard slog on its hands. As I wrote in the first article:

“Noble had announced two sets of quarterly earnings (for the fourth-quarter of 2014 and first-quarter of 2015) since the release of Iceberg Research’s first report. Both sets of earnings were anything but healthy; the fourth-quarter earnings saw Noble clock a quarterly loss for the first time in three years while the first-quarter earnings had the firm’s revenue and profit for the quarter suffer year over year declines of 7% and 30% respectively.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Chipotle Mexican Grill.