Seth Klarman: The Demonization of Short-Seller

Seth Klarman defends short sellers, i.e. Daniel Loeb, in his 2010 annual letter:

While we rarely sell securities short – both because of the degree of execution difficulty and theoretically unlimited risk compared to limited potential return – we do believe that short-selling serves a vitally important function.

BAUPOST GROUP

Markets, of course, fluctuate; driven by human emotion, greed, and fear, they can reach significantly overvalued levels. This is bad, both because it can induce some who cannot afford losses to speculate, and because it can lead to an improper allocation of society’s resources. The recent housing bubble illustrates the problem: excessive home prices led to excessive home building, eventually resulting in a price collapse, large loan losses, and great personal hardship. In addition, the decline that follows periods of market overvaluation is bad for the broader economy, for confidence, and for rational decision making; it also frequently triggers government intervention in markets, with all of its inevitable distorting effects. Just as value buyers can dampen downside volatility, short-sellers can dampen the upside excesses. They don’t actually change the eventual outcomes, just help us get there sooner. This makes short-sellers unpopular, as the uninformed masses enjoy high and rising securities prices for the short-term profits they produce, without understanding the societal costs of the future reversal. The less you understand valuation, the more that overvaluation seems like a free lunch – which of course it isn’t.

From our experience, much long-oriented analysis is simplistic, highly optimistic, and sloppy. Short-sellers, by going against the long-term tide of economic growth and the short-term swells of public opinion and margins calls, are forced to be crackerjack analysts. Their work product is usually top-notch and needs to be. Short-sellers shouldn’t be reviled or banned; most should be celebrated and encouraged. They are the policemen of the financial markets, identifying frauds and cautioning against bubbles. In effect, they protect the unsophisticated from predatory schemes that regulators and enforcement agencies don’t seem able to prevent.

Moreover, the short-seller who is fundamentally wrong, who mistakenly sells short an undervalued security, will lose money and, if the pattern continues, will eventually go broke. Short-sellers, like long-only buyers, need to be right more than they are wrong; when they are right, their actions are socially beneficial, not harmful. The only exception to this point, the only danger short-sellers pose to society, is when, in the equivalent of yelling “fire” in a crowded theatre, they spread false rumors that prevent a company that needs regular financing (such as brokerage firms) from being funded. Then, their predictions become self-fulfilling prophecies, enabling them to profit, whether or not they were fundamentally correct; they may actually be able to change the outcome. Yet, even in this situation, one may wonder whether any company – or highly leveraged government, for that matter – should employ a funding model that depends on perpetual access to the capital markets, which are notoriously fickle, volatile, subject to the influence of malicious gossip, and short-term oriented. In any event, mechanisms such as the uptick rule and rules against market manipulation already exist to prevent such misbehavior by short-sellers.

blog comments powered by Disqus
Insider Monkey Headlines
Insider Monkey Small Cap Strategy
Insider Monkey Small Cap Strategy

Insider Monkey beat the market by 52 percentage points in 24 months Click to see monthly returns in table format!

Lists

50 Crazy Facts About Japan You Won’t Believe

Top 10 Least Expensive Hybrid Cars to Save the Planet With

The 10 Biggest ‘Gate’ Controversies in History

The 10 States with the Highest Nursing Shortages Leaving Their Hospitals Depleted

The 10 Best Value Investment Blogs that Every Investor Must Read

The 6 Cheapest Boarding Schools in Europe 2015

The 5 Most Expensive Cars To Insure in the World

The 10 Most Common Genetically Modified Foods

10 Self-Made Billionaires Who Came From Nothing

The 10 Most Expensive Cities to Live in North America

The 13 Most Expensive Headphones in the World to Represent

The Top 20 Wealthiest Soccer Teams in 2014

4 BuzzWorthy Cannabis Stocks And Some Smoking Derivative Plays

The 10 Healthiest Fast Food Chains in America to Dine At

The 5 Most Expensive Cat Food Brands You Can Spoil Your Kitty With

The 6 Best eCommerce Platforms for Small Businesses

The 10 Worst Mistakes an Entrepreneur Can Make

The 5 Most OP Characters in League of Legends to Carry Games and Crush Foes With

The 5 Best Foods to Eat Before Running that Will Help You Pound the Pavement

10 Glaring Plot Holes in The Walking Dead that a Zombie-Filled Bus Could Drive Through

The 5 Biggest Celebrity Stoners Who Love Their Reefer

The 10 Most Overrated Movies Of All Time by Out-of-Touch Critics

Top 6 Least Expensive Cruise Destinations For 2015 that Will Take You to Paradise

10 States with Lowest Substance Abuse Rates in America

The 14 Most Watched TV Finales Ever

The 10 Best Selling Role Playing Games of All Time for PC

10 Most Influential Papers In Economics

Top 8 Biggest Charities in the US

10 Worst Celebrity Career Moves Ever

Top 10 Best Paid Tennis Stars in the World

10 Cities with High Demand for Nurses

6 of the Worst Greeting Card Messages Ever Crafted

How to Make Money in ArcheAge and Build Your Empire

10 Foods To Eat To Lower Cholesterol Levels

The 10 Most Hated Television Characters of All Time

The 30 Worst Halloween Costume Ideas Ever Brought to Horrible Life

10 Vocational Skills in Demand Today with Jobs Waiting to be Filled

10 Best Places to Visit in Central and South America

The 10 Greatest Empires in History Which Nearly Conquered the World

The 6 Cheapest Boarding Schools In America 2015

5 Clear Reasons LoL is Better than DotA, Continues to Rule MOBAs

The Only 9 Teams with a Chance to Win the Super Bowl

The 15 Most Common Phobias in America that Induce Fits of Panic

Top 6 Least Expensive Tourist Destinations in 2014

Jim Goetz, Peter Fenton, Jim Breyer: Top 6 Venture Investors for 2014

Top 15 Billionaires in 2014

5 Pitfalls To Avoid When Buying a Franchise

Top 20 Medical Schools in the US – 2014 Rankings

4 Business Strategies that Turned Jamie Oliver into the World’s Richest Chef

6 Qualities That Make You A Good Team Player

Subscribe

Enter your email:

Delivered by FeedBurner

X

Thanks! An email with instructions is sent to !

Your email already exists in our database. Click here to go to your subscriptions

Insider Monkey returned 47.6% in its first year! Wondering How?

Download a complete edition of our newsletter for free!