Large Short-Sale Positions Sign Of Potential Trouble

Sometimes, even the paranoid have enemies.

In recent years, the practice of short-selling - selling borrowed shares of stock - has been sanitized in market analysis and commentary.

Instead of being an indicator of suspicions about a company and its stock price, short-selling often is viewed merely as a reflection of complex trading strategies unrelated to company fundamentals.

Or, the short-sale position in a stock is described as a bullish indicator, because shares sold short must be repurchased at some point and therefore form a base of demand for the stock. Several studies have shown that short-sellers are poor market timers.

Companies whose shares are subject to heavy short-selling promote this benign point of view and frequently complain that short-sellers are evil manipulators who spread false rumors to drive down their stock.

Now, two academics - Paul Asquith of the Sloan School of Management of the Massachusetts Institute of Technology and Lisa Meulbroeck of the Harvard Business School - have written a paper that suggests much short selling is being done for the reason that makes the most sense: The stock’s price is believed likely to fall and the short-seller can repay the borrowed shares at a cheaper price, pocketing the difference.

Byron Wein, respected market strategist for Morgan Stanley, cited the paper, “An Empirical Investigation of Short Interest,” in a recent newsletter.

“This is pretty convincing evidence for an important counter-consensus observation, that investors should further short the stocks already heavily shorted,” Wein concluded.

Asquith and Meulbroeck said companies that had more than 5 percent of their shares sold short tend to underperform the market.

Having more than 5 percent of a company’s stock sold short is a significant position. In the August report on short sales by the Nasdaq market, Microsoft shows a short-sale position of 5.8 million shares. But that represents less than 1 percent of the stock. On the New York Stock Exchange, Ford Motor had 29.1 million shares sold short, representing less than 3 percent of the stock.

Also, short-selling often relates to a proposed merger, wherein investors will buy stock in the target company and sell short the acquirer. The largest NYSE short-sale position in August was in Walt Disney, which is seeking to buy Capital Cities/ABC.

But there are also signs of major short-selling that seems to be driven by fundamental analysis. For example, the largest Nasdaq short-sale position in August was American Power Conversion, whose power-control technology is used in personal computers and computer networks.

The company had 12.2 million shares sold short, representing 13 percent of the outstanding shares. The share price peaked at $28.75 in March 1994, and has been heading south after a rally in June. The company’s second-quarter earnings report disappointed investors. Friday, the stock closed at

Perhaps the most successful short-sale of the summer was Arakis Energy, a Canadian natural gas producer traded on the Nasdaq market.

Nearly 10 percent of the stock was sold short, up sixfold from July, as of the mid-August Nasdaq report. A few days later, the company’s ambitious plan to finance exploration in Sudan ran into difficulties. Nasdaq trading in the stock has been halted since Aug. 23.

“I don’t think it’s a good idea to just short the list of stocks with large short positions, as it stands,” Wein wrote. But a large-percentage short position - in the absence of a merger deal - should be a red flag to investors.