The Information Content of Short Selling Around Close Supply Chain Relationships

• DOI: http://doi.org/10.1111/fire.12163
• Author: Dominique G. Outlaw,Jocelyn D. Evans
• Published date: 01 August 2018
• Date: 01 August 2018

The Financial Review 53 (2018) 627–655

The Information Content of Short Selling

Around Close Supply Chain Relationships

Jocelyn D. Evans

College of Charleston

Dominique G. Outlaw∗

Hofstra University

Abstract

Close supply chain relationships are sometimes detrimental to the partnering firms, and

short sellers recognize this before the rest of the market. Suppliers and customers that are in

linked, close supply chain relationships have higher short interest on average. Further, higher

short interest increases the likelihood of large, linked customers reporting negative earnings

surprises, whereas suppliers with high short interest are more likely to report negative earnings

surprises, irrespective of the supply chain structure. Short selling is informative to capital

markets because these suboptimal relationships eventually lead to dependent suppliers being

delisted from a stock exchange for financial distress reasons.

Keywords: trade credit, financial distress, short selling, negative earnings surprise

JEL Classifications: G01, G30, G32, G33, G14

∗Corresponding author: Hofstra University,1000 Fulton Ave, Hempstead, NY 11557; Phone: (516) 463-

5083; E-mail: Dominique.Gehy@hofstra.edu.

We thank Wes Burnett, Jared Delisle, Ahmet Karagozoglu, Haim Kassa, Phyllis Keys, James Malm,

Mari Robertson, Jeff Shockley, and the seminar participants at the College of Charleston, University of

Cincinnati, and Hofstra University for comments on this paper. We also thank the anonymous referees,

Editors Srinivasan Krishnamurthy and Richard Warr, discussants and session participants at the Eastern

Finance Association, Global Finance, and Financial Management Association 2017 annual meetings.

Support from the College of Charleston Research Fund and Hofstra University Summer Research Grant

is greatly appreciated.

C2018 The Eastern Finance Association 627

628 J. D. Evans and D. G. Outlaw/The Financial Review 53 (2018) 627–655

1. Introduction

Akbas, Boehmer, Erturk and Sorescu (2017) show that several months before

information becomes public, the level of short interest contains value-relevant in-

formation. In particular, they provide evidence that short interest predicts future

bad news, negative earnings surprises, and downward revisions in analysts’ earnings

forecasts. Their evidence shows that the cross-sectional relationship between short

interest and future stock returns is related to undisclosed information, which reflects

sophisticated investors’ ability to uncover unfavorable information about companies

from a variety of formal and informal sources.

As an extension of this line of research, we examine whether outstanding short

interest predicts unfavorable information related to the existence or absence of close

supply chain relationships between a customer and a supplier. This is an important

issue because negative information may not be readily revealed to capital markets

when customers and suppliers have close supply chain relationships. When operating

conditions decline for one firm in the supply chain, all of the other firms are also

at risk. This leads us to the following research question: For firms in linked supply

chain relationships, do sophisticated investors’ trades act as an early warning signal

of bad news? The bad news could be related to the announcement of negativeearnings

surprises or to the firm being delisted from a stock exchange due to financial distress

reasons. In our analysis, a linked relationship is defined as a large customer that

represents at least 10% of its suppliers’ revenue, whereas an unlinked customer is not

as economically important.

The results are consistent with short sellers focusing on supply chain-related

information asymmetries for poorly performing customers or suppliers. Using a

difference-in-differences test, we find that short interest is higher in the period prior

to the initial disclosure that a large customer or a supplier has formed a linked supply

chain relationship. The unique result is that sophisticated investors are able to time

their trades prior to changes in supply chain relationships—revealinga firm’s financial

performance issues. The combined results are consistent with close supply chain

relationships facilitating opaqueness and earnings problems that go unnoticed by

less-informed investors. Short selling, however, mitigates the information asymmetry

inherent in close supply chain relationships and is associated with some dependent

suppliers going dark, for example, eventually delisting from stock exchanges. Higher

short interest leads to greater incidences of negativeearnings surprises for all suppliers

and for large, economically important customers. Hence, it appears that high short

interest occurs because of supply chain-related information asymmetries about lower

than expected earnings, which should be of concern to investors in the capital market.

The finding that short sellers target economically important customers and dependent

suppliers is consistent with supply chain relationships sometimes having illusionary

benefits, when other conditions remain the same.

To our knowledge, this is the first empirical study that provides evidence that

short sellers target firms based on a close supply chain relationship due to information