Short selling pins hopes on decline in stock price

January 06, 1994|By Ian Johnson | Ian Johnson,New York Bureau

NEW YORK -- Once they strode down Wall Street, causing mighty companies to quake at their pronouncements. Now, short sellers are more likely to be found writing newsletters or standing in a bread line.

Their descent says much about the three-year bull market: Short sellers make money when stock prices fall, so many have been drowning amid the rising market.

That's a far cry from the 1980s, when an erratic stock market provided choice pickings for Wall Street's professional pessimists. Best known among that swashbuckling crowd were the Feshbach brothers of San Francisco, who once had $1 billion under management but now have a reported $120 million.

In their best-known case, the Feshbachs helped expose fraud by officials of ZZZZ Best Inc., a janitorial service. The company was a stock market darling after going public in the mid-1980s.

The brothers hired a private investigator who turned up evidence that ZZZZ Best officials used deceptive bookkeeping practices. That evidence showed ZZZZ Best was worth only a fraction of the amount reported by the company and helped to send the chief executive and others to jail on securities fraud.

As ZZZZ Best stock plummeted, the Feshbachs profited through short selling's unusual procedure of borrowing stock and betting that its price will go down.

Here's how it works: An investor identifies a stock as overvalued -- either because it's been bid too high by eager investors or because of a fundamental problem within the company.

Consider a stock priced at $30. The investor borrows 100 shares from a broker and sells them in the market for $3,000. Then the investor waits, hoping that the price will fall. Say it goes down to $20. The investor buys 100 shares for $2,000 and returns those shares to the broker. The investor pockets the $1,000 profit, minus commissions and charges.

But if the stock price rises to $40, the investor must make a choice: Either cut and run by buying the stock at $40 and suffering a $1,000 loss, or wait and hope the price goes down.

Will Lyons, editor of the Short On Value newsletter in Atlanta, said most short sellers function as an insurance policy -- or "hedge" -- for big money managers. Worried that the stock market may crash, the managers give part of their money to short sellers to invest.

If the market falls, their losses are likely to be cushioned by profits from the investments made by short sellers, who collect a fee for the service.

"There are not too many left who actively try to push a stock price down. Most are sophisticated professionals," Mr. Lyons said.

Ben Capaldi, for example, runs Chestnut Hill Advisers, a $10 million hedge fund in Blue Bell, Pa. His computer model identifies highly valued stocks that have just reported disappointingly low earnings. He shorts these stocks, anticipating that prices will fall.

"Still, we only short 40 percent of our money," Mr. Capaldi said. "Not many people are 100 percent short anymore. It's too risky."

Short sellers help balance Wall Street's eternal cheerfulness, said David E. Nelson, director of equity research at Investment Counselors of Maryland.

"Wall Street has a bias for pushing things up," he said. "The shorts come in and rationalize the price."

Some short sellers, however, have earned a bad reputation for being too active. Although the Feshbachs and others have helped expose fraud, some short sellers have tried to force a stock price down by actively lobbying against a company, Mr. Lyons said. Such actions might include planting stories in the media.

Short sellers also might try to lobby the Securities and Exchange Commission to investigate a company, and then tell the media that the company is being probed, he said. A well-timed negative article or broadcast can drive down the stock price and earn a tidy sum for the short seller -- even if subsequent events prove that the company's practices are sound.

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