Reddit Jolts Activist-Short Hedge Funds Into ‘Adapt or Die’ Mode
Shorting stocks has never been an easy way for a nice person to make a buck. For most of the bull market that followed the 2008 financial crisis, it was an outright nightmare.
But this? This is something else, as swarms of traders crowded in internet chatrooms storm together into long positions of heavily shorted companies. They are calling out — by name — the fund managers they hope to squeeze out of business, while reaping triple-digit short-term returns in the process.
The drama is causing a sudden re-think among the relatively small number of firms that successfully focus on activist shorting, a strategy that involves betting against a company and publishing research reports intended to convince shareholders the stock is overvalued. As Ben Axler of activist short-selling hedge fund Spruce Point Capital put it: “Adapt or die.”
“Risk management is critical during euphoric periods unhinged from fundamentals,” Axler said. “It’s become more critical to understand who’s on the other side of the trade, and what the bull case is. Markets have always been ‘adapt or die,’ and today is no different.”
The growing mobs on Reddit’s WallStreetBets forum and other favored social-media destinations are leaving some serious wounds in the hedge-fund space. Melvin Capital Management started 2021 with a loss of about 30% because of short positions on GameStop Corp. and other companies that went awry. Citron Capital’s Andrew Left, a popular target on Reddit, said on Wednesday his firm closed out of a GameStop short bet “at a loss of 100%.”
Carson Block, who made a name for himself with numerous successful short sales of Chinese companies, said his Muddy Waters Capital “massively reduced” its short positions in recent days, mostly sidestepping the buying frenzy that has burned some peers.
Others claim to have escaped. Gabriel Grego, chief investment officer at Quintessential Capital Management, says the firm wasn’t affected by any of the recent squeezes. Still, it’s putting new short campaigns on hold.
“It’s given us a lot of room for thought because maybe the next target that we choose is going to be the reason investors pile on it like they did with GameStop or AMC,” he said. Until the situation stabilizes or “markets go back to sanity,” the firm is looking for new opportunities outside of the U.S. where this type of dynamic has not materialized.
Another option under consideration is to find new ways to be an activist such as betting on higher volatility of a stock rather than selling it short.
“If the markets act rationally, the stock price should drop,” Grego said. “If they act irrationally, they would just massively rip, so it would make sense to go long volatility rather than taking a simple short.”
The tactics being promoted on the message boards often focus on forcing both short-sellers and equity-options dealers to buy shares and pump up prices way beyond reasonable values. Viewed one way, the Reddit mobs may serve as something like a new sheriff in town walking the short-seller beat.
‘Smash and Grab’ Over
The days of “smash-and-grab” shorting are over, according to veteran bear Marc Cohodes, referring to investors who release a critical research report and then quickly cover their positions following an initial share price drop — or those who piggyback on others’ work and crowd into bearish positions. More discipline will be required, he says.
“The last thing the referee tells you when you’re in a boxing match before they ring a bell is ‘protect yourself at all times,’” he said. “And these big hedge funds who’ve been short and over-concentrated in these names have been arrogant, pompous and didn’t realize they were overstretched.”
The big lessons of the last week are pretty simple, according to Fraser Perring, founder of Viceroy Research: “If you go short, make sure you have a position that in some way preserves some capital if the trade goes against you in the short term. If the cost of that strategy is too high, the risk isn’t worth it. Price discovery is officially suspended.”
To be sure, many of the short positions that were flushed out recently would’ve been considered highly risky — even before the pyrotechnicians of today’s commission-free trading world began squirting gasoline on them. GameStop, for example, traded with short interest much higher than 100% of its free float due to bearish traders who borrowed and sold shares that had already been borrowed and sold.
“Why people are trying to short a company with 141% short interest, I don’t know,” said Perring. “We avoid them because we’re just going to get drowned out by this. The people have worked out that, on high short-interest stocks, if you get a couple of thousand people buying a few thousand worth of calls and a bit of equity, they can run you over.”
Of course, when a short seller does get run over, there is often little sympathy except among fellow travelers of this investing road less taken.
Specializing in shorting equities as a hedge-fund strategy has always required fighting off or withstanding personal vilification by the executives and shareholders of the companies targeted. One fund manager’s “exhaustive, critical research” is another C-suite executive’s slings and arrows of outrageous fortune. As a result, even an impressive history of returns in a bull market may not guarantee a commensurate reward of cash from clients.
That means the current chat-room campaigns could pose an existential crisis for some activist shorts. Investors with deep pockets and an abundance of patience to ride out bad shorts, like Bill Ackman’s famously futile five-yearcampaign against Herbalife, are few and far between.
“It’s about who can stay solvent the longest,” said Perring of Viceroy. “And we know that’s not the shorts.”
Still, for every crisis there is opportunity, and shorts probably know this better than anyone. While hordes of newly minted day traders may be destroying bearish positions, the message-board culture of 2021 has also created excessive bullishness in some stocks that could prove to be fertile ground for future bears, according to Sahm Adrangi, founder and chief investment officer of Kerrisdale Capital Management, a hedge fund with $700 million in assets that focuses on activist short-selling.
Adrangi is not convinced that the strategy of publicizing critical research will end up a casualty of this year’s speculative frenzy, even after his firm became a target of message-board traders.
“I don’t think we’ve ever been trolled or targeted as much as now, but it’s part of what we do,” he said.
Some of his firm’s recent targets — Plug Power Inc., FuboTV Inc. and Tattooed Chef Inc. — plunged as much as 9% to 17% during the session after the research was released. Each stock recovered some off its low of the day, but still ended down at least 6%.
“It’s great for us if you get a ton of investors that crowd into a name on the long side and they don’t know what they own,” he said. “When we share our research, they’re going to pay attention and there will be a ton of volume. There’s going to be a real debate and it won’t be a bunch of sleepy mutual funds. We don’t have a problem with it.”
— With assistance by Vildana Hajric, and Erik Schatzker
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