How to short sell stocks

A commenter on the post about Herbalife recommended the blog of short-seller John Hempton of Bronte Capital in Sydney. Here Hempton is explaining short-selling to his 12-year-old son:

We also talked at length for the first time about our business. We run a hedge fund. Our job is simple: make rich people richer through investing, trading in financial markets. 

Half of that is relatively easy to explain: we buy shares in good companies. ... 

But then the area our fund is best known for came up. I am a short seller.
I went through the mechanics of short-selling. I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up. 

Then I got to the nub of the issue: I am a short-seller of frauds and stock promotes. I look for people in the stock market who have fake accounts and who are stealing from gullible shareholders (also known as marks, dupes, fools, day traders or mutual fund managers). There is a torrent of money being ripped off (many billions of dollars for instance in the case of the Chinese frauds a surprising amount of which came from Fidelity). Through short-selling I stick up my sail on my little boat in the hurricane of theft and some of that loot drops into the cabin. 

He asked me how I find all these fake accounts and fake companies and I told him a few of our methods (we have many). 

He asked if I ever dobbed the scammers in to regulators and I said I did sometimes but it was mostly not a satisfactory experience. To be a good short-seller I only need to be right about 90 percent of the time. If most the companies I short-sell have fake accounts I will do fine. However if I dob them into regulators I need to be absolutely right in that it does not bode well to dob an honest person into the authorities. So mostly I keep my gob shut and express my opinion (and it is an opinion) in a bet in the financial market. 

Moreover talking about which stocks you think are frauds is a dangerous thing. Regulators sometimes (even foolishly) have been known to investigate short-sellers for telling the truth. (Being short Lehman Brothers and vocal about it was a good way of getting an SEC investigation for talking truth to power.) Also crooks sue short-sellers giving you nasty and expensive legal bills. 

Silence is altogether a better strategy. 

But then he came to the nub of the issue. The easiest scammer to find is a repeat offender. We actively seek out people who promote dodgy stocks and who who are repeatedly involved in dodgy companies. The slogan is “once a scumbag, always a scumbag”. That slogan is probably not strictly accurate -  but we only need to be right 90 percent of the time to be fantastic at this business – and the recidivism amongst scammers is surprisingly high. 

Chris Brand talked about a "g factor" for committing crimes, that would be just plain dishonesty. It seems to be a pretty persistent character trait.

Hempton cites Steve Madden, the dodgy shoe designer in The Wolf of Wall Street, as his nightmare counterexample. Madden went to prison for crookedness involving his IPO, but has made a bundle since he got out designing shoes that teenage girls think make them look hot. The market cap of his company is now over $2 billion.

In that sense long sentences for people like Bernie Ebbers are not in my interest. I would prefer slime-bags to be back-in-business rather than in prison. More opportunities for me. 

So, perceptively my son asked whether it was in my interest to dob scammers into regulators – he asked whether the reason we did not do it much was because of the reasons stated above or because we liked the scammers to be free and profitable. Alas – and I had to confess it – at least part of it was that being a successful short-seller required that regulators were inadequate to the task of policing fraud. 

I did not talk about this with him – but it is becoming harder under Mary Schapiro. The SEC is getting better at their job – and that is not good for me. It would be better if regulators stayed hopeless. Alas they are getting better. 

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you? 

Sheepishly I confess yes. 

And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.