Short Selling and Firm Operating Performance

• DOI: http://doi.org/10.1111/fima.12081
• Author: Keith M. Howe,Sanjay Deshmukh,Keith Jacks Gamble
• Date: 01 March 2015
• Published date: 01 March 2015

Short Selling and Firm Operating

Performance

Sanjay Deshmukh, Keith Jacks Gamble, and Keith M. Howe∗

While it is well known that short selling predicts future negative stock price performance, it has

not been established whether short selling predicts future negative operating performance. We

find that firms in the top decile of increases in short interest (an increase of about fourpercentage

points) experience a 21% subsequent decline in operatingperformance relative to matched control

firms. The greater the increase in short interest, the larger the declinein operating performance.

The results arerobust to alternative performance measures and to sample splits based on firm size.

These results suggest that short interest may reflectprivate information about firm fundamentals

rather than other factors that may drive stock price changes.

In spite of its dramatic growth over the last several decades, short selling remains highly

controversial.Shor t selling can arise from market making, whichprovides liquidity to the markets,

and from hedging, which allows users to manage risk more effectively.Moreover, a large segment

of market participants believes that short sellers contribute to price discovery making markets

more efficient by allowing prices to reflect a more negative sentiment. Critics disparage this

claim by arguing that short sellers manipulate share prices to seek profits. The central question

that arises is: Do short sellers exhibit an ability to identify overpriced stocks by anticipating

deteriorating firm fundamentals?

It is widely acknowledged that short sellers are motivated by trading profits. Prior research

examines the relation between short selling and subsequent stock returns, corporate announce-

ments, and analysts’ earnings forecasts. These studies, however, do not make an explicit attempt

to identify whether declining firm fundamentals induce short sellers to trade. In addition, as

we note in Section I, the extant empirical literature on short interest only provides indirect and

inconclusive evidence concerning the central question weraise. The reason is that the relationship

between short selling and stock returns, corporate announcements, and earnings forecasts may be

driven by factors unrelated to firm fundamentals. Further, some of this evidence is susceptible to

an endogeneity problem. Thus, it is not clear whether short selling is motivated by deteriorating

firm fundamentals or by factors unrelated to fir m fundamentals that nonetheless affect stock

prices and thus trading profits.

It is important to differentiate between these two potential sources of profits from a regulatory,

market efficiency, and price discovery perspective. If the actions of short sellers are driven

by worsening firm fundamentals, then these actions are likely to provide useful information

to other market participants in the capital allocation process and would represent a positive

∗Sanjay Deshmukh is an Associate Professorin the Department of Finance in the Driehaus College of Business at DePaul

University in Chicago, IL. Keith Jacks Gamble is an Assistant Professor in the Department of Financein the Driehaus

College of Business at DePaulUniversity in Chicago, IL. Keith M. Howeis the Dr. WilliamM . SchollProfessor of Finance,

Emeritus, in the Department of Finance in the Driehaus College of Business at DePaul University in Chicago, IL.

Wethank Charles Jones and Wei Xu forproviding us the data on short interest for NASDAQf irms. We are gratefulfor the

valuable suggestions and guidance providedby Marc Lipson (Editor) and an anonymous referee. We are also grateful to

Charles Jones, Jonathan Karpoff,Tunde Kovacs, and VahapUysal for their comments and suggestions.

Financial Management •Spring 2015 •pages 217 - 236

218 Financial Management rSpring 2015

externality. In contrast, if short selling is motivated by factors unrelated to firm fundamentals,

then the documented evidence would indicate that short sellers principally trade to exploit market

inefficiencies.

We employ a distinctive approach to disentangle this empirical puzzle on short selling. Our

premise is that if short selling is motivated by deteriorating firm fundamentals, then changes in

short interest should be related to subsequent changes in operating performance. The approach

we employ focuses directly on the firm’s operating performance, an important element of firm

fundamentals. Specifically, we examine the operating performance of firms, relative to a control

sample, following large increases in short interest. The performance measures we use are based

on operating income and cash flow, the fundamental drivers of firm value.

The theoretical underpinnings for our study stem from Diamond and Verrecchia (1987), who

develop a rational expectations model of the effect of short sale constraints on the distribution of

prices and their speed of adjustment to private information. One important empirical prediction

of their model is that an unexpected increase in the announced short interest in a company’s stock

represents bad news. A follow-up prediction indicates that the larger the unexpected increase in

short interest, the greater the price adjustment. Since stock prices are based on fir m fundamentals,

among other factors, we drawon these predictions to derive and test two hypotheses related to firm

fundamentals. Our first hypothesis states that an unexpected increase in a firm’s short interest

will be followed by a decline in its operating performance. The second hypothesis states that the

greater the unexpected increase in a firm’s short interest, the larger the decline in its operating

performance.

To test these hypotheses, we follow the method in Barber and Lyon (1996) for ex post event

studies that use an accounting-based measure of operating performance. The most important

feature of this method is matching event firms to control fir ms with similar pre-event operating

performance, along with size and industry, to ensure that test statistics are properly specified.

This method allows us to address the central question most directly. Our primary measure of a

firm’s operating performance is the ratio of operating income before depreciation (OIBD) to total

assets. We also consider several alternative measures, one of which is based on cash flow.

Our results indicate that a large increase in short interest is associated with a significant decrease

in operating performance in subsequent years. Specifically, firms in the top decile of short interest

increases in a given quarter experience a decline in operating performance over the following

three-year period. Firms in the top decile experience an average increase in short interest of about

4.01 percentage points with the lowest increase equaling 1.05 percentage points. The decline in

operating performance, relative to a matched control sample, is approximately 21% of the mean

level of operating performance of these firms before the rise in short interest. We also find a

monotonic relationship between the size of the increase in short interest and the magnitude of

the decline in operating performance. Our findings are robust to several alternative measures of

operating performance. The results are independent of firm size in that we obtain similar results

when we split our sample into three groups based on firm size. In addition, we find that short

selling is higher in firms that have experienced improved operating performance. This result

provides new evidence concerning the type of fundamentals-based information that short sellers

might use before increasing their short position. The result also rules out endogeneity arising

from reverse causality since, contrary to public perception, short sellers do not target only poorly

performing firms, causing their performance to decline fur ther through relentless short selling.

However, in some cases, short sellers do intentionally cause further deterioration in operating

performance through persistent attacks on the firm.

Our overall results indicate that operating performance declines in firms that experience a spike

in short interest, which provides strong support for our hypotheses. These findings suggest that