Interpreting short-seller reports

General Electric was hit with unwelcome publicity in August when Harry Markopolos — best known for trying to blow the whistle on Bernie Madoff’s $65-billion Ponzi scheme — accused GE of committing a $38-billion accounting fraud.

Different from regular short trades or strategies, short campaigns are when an investor takes a short position in a stock and then issues a public report criticizing the company.

The GE report ticked many of the boxes that short-sellers aim for when publicly targeting a stock. It featured a company that has nebulous dealings in multiple industries, and by extension has some fairly impenetrable financial reporting. The report focused on several accounting issues, which immediately implied, rightly or otherwise, some sort of malfeasance. And it drew parallels to well-known collapses, including Enron and Worldcom.

Focusing on accounting issues works well for short campaigns because the accounting rules themselves are wide open to interpretation. Management must use their judgment and assumptions to craft the financial figures, which are more estimates than measurements. A short-seller might perceive that those accounting assumptions are too aggressive. They might also claim that the accounting rules were misapplied, or that their application distorted what is known as the fair presentation of the financial statements.

A short campaign creates its own catalyst, especially when accounting issues are the focus. Unlike valuation concerns, accounting issues rarely surface on their own. Some short-sellers hope to capitalize on immediate panic and confusion, as they know the average investor is ill-equipped to deal with arcane accounting arguments.

Short-sellers can also amplify panic by, deliberately or otherwise, misstating facts or making material omissions. These are known as “short and distort” campaigns. That’s how GE characterized the Markopolos report; CEO H. Lawrence Culp, Jr. called it “market manipulation — pure and simple.”

Short campaigns becoming more popular

Short campaigns have exploded in popularity over the past decade. Short ideas were not always shared so publicly, but then short-sellers realized that jump-starting the process by widely disseminating the reports could be more profitable. There are carrying costs to sitting on short positions, and the benefit of the public panic factor can’t be overstated.

Examining the track records of many short-campaign firms underscores that they are just like regular investors, capable of stellar hits as well as spectacular misses. Citron Research did much to lift the veil on improper accounting at Valeant Pharmaceuticals (now Bausch Health) in 2015, before the stock plummeted. Citron followed that with a short call on Shopify Inc. in 2017. That stock has, unfortunately for Citron, skyrocketed 250% since.

Dealing with short-seller reports

How do advisors assess the merits of a short campaign without knowledge of the accounting, legal or regulatory issues that often underlie the thesis? While short-campaigners have evolved, companies have also become more skilled at responding to short reports. Investors can likewise become better equipped at interpreting those responses.

Investors should expect companies to identify errors, clarify issues and respond to short campaigns in a fairly expedient manner; however, executives shouldn’t allow themselves to become distracted or take issues personally. This can happen to even the best at first, especially when top executives exert significant control (such as a founding CEO). But in some cases, a prolonged over-reaction has been a sign that something is very rotten.

MiMedx Group was a healthcare company that came under the scrutiny of several short-sellers starting in 2017. The response by the founder and CEO could not have been more volatile, including filing lawsuits against short-sellers, threatening a short-squeeze using company funds, and dedicating a section on the company’s homepage to ongoing “short selling commentary.” In the end, the CEO was fired for accounting manipulation going back years and the stock dropped over 90% before making a partial recovery.

Advisor intuition can be more than enough reason to sell a stock when executive credibility on accounting issues is in question. The tone of management’s reaction to a short report can be more telling than a ream of opaque financial disclosures, with the latter often only providing more questions than answers.

Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.