Should I Worry If My Investment Has Short Interest?

Investors who believe that a company is overvalued in the stock market can short sell a company and profit when the company depreciates in value.

Although this may not be a common approach for most retail investors, professional money managers often use this strategy to hedge against a bear market and to make money off over-valued stocks.

Even if we do not use shorting as part of our investment strategy, finding out if companies have been “shorted” can provide valuable insight to investors.

A high short interest could be a warning to investors

Short sellers are often considered the smart money in the world of equities. It is extremely difficult to survive as a short seller due to the hostility from companies who find out about the short interest and the additional risks the sellers incur to short sell a company. The risks include unlimited downside potential and the “short squeeze” (when all short sellers close their position at once, causing the share price to rise suddenly).

Therefore, short sellers have to be extremely confident and have high conviction that the company they are short selling is either fraudulent or vastly over-valued.

For instance, a Massachusetts Institute of Technology and Havard study done in 2004 found that stocks with the highest short interest under-performed the market by an average of 125 basis points per month (or 15% per year).

“Short sellers” have been known to shine the spotlight on fraud

Another advantage of short interest is that they have been known to sieve out fraudulent companies.

Bill Ackman, for instance, made a famous bet against a multi-level marketing company as he believed the company used fraudulent methods to grow their sales, such as pyramid schemes to attract customers.

The company eventually settled for a $200 million fine and was given restrictions on its business model. The spotlight on the firm exposed these activities and ensured that the company tweaked its business proceedings.

The Foolish takeaway

Short sellers are useful in helping the authorities spot fraud and ensuring that companies are priced reasonably in the stock market. This is a good thing for all stock investors.

If the company you have invested suddenly attracts short interest, it may be wise for investors to relook at the fundamentals of the company and assess the quality of the business.

Having said that, short sellers are not always right. If we have reason to believe that their thesis may be flawed, betting against them can be hugely rewarding, especially when you believe a “short squeeze” is just around the corner.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.