Don't Panic: How Long-Term Investors Should Handle Short Seller Reports
How investors respond in the face of a short attack can say a lot about their level of conviction and their depth of research
A Flyover Stocks subscriber recently pointed out a short report against The Toro Company, a company I profiled in April, and asked for my thoughts.
I'll get to that in a moment (available to paid members), but it seemed like an opportune time to discuss how investors should consider short reports on companies they own.
To start, I like short reports. I enjoy reading (most of) them. Short reports are generally well researched and necessarily so, given the additional risks involved with shorting. Some of them are too long and hyperbolic, but that’s by design.
So, what should you do when a short seller publishes a report against one of your companies?
The best approach is to have done good research upfront. One reason short reports are usually lengthy, detailed, and intense is to shake out weak hands on the long side.
If you panic when you find out there's a short report about a company you own, it means you haven't earned the right to own the shares in the first place.
Position sizing also comes into play here.
As you size a position, you must consider how well you know the company. I'm not talking about superficial factoids like the company’s address or what year it was founded; I'm talking about the DNA, the essence, the nature of the business itself.
Put differently, do you understand the good, the bad, and the ugly?
If a company accounts for more than 5% of your portfolio, there shouldn't be anything in a short report that comes as news to you. You may agree that a point raised is a risk, but the important thing is that you've identified it and implemented it in your evaluation. Nothing should come out of left field with a large position.
One way to test the depth of your understanding of a business is to ask yourself if you could confidently go on CNBC or Bloomberg TV and debate a well-informed short on the company. If the answer is no, you need to do more work before sizing up the position.
Next, actually read the report. Take it seriously, and don't dismiss it out of hand. You might have missed something or discover a method for measuring a company's progress that you hadn’t considered.
Once a short report has been published, it's also an invaluable time to watch how management responds. Do they respond at all? If they do respond, are they being civil and constructive or defensive and sensitive?
I was once an investor in a company that I thought highly of until the CEO, facing some short-selling pressure, told me he wanted to "stick it to the shorts" while saying elsewhere that he ignored the stock price.
That's not the response you want from your companies.
One of my favorite responses came from Fastenal founder Bob Kierlin. In 1992, Fastenal had 13% short interest, and in a Forbes article of the same year, Kierlin said:
"I've got nothing against short sellers…They have a role in the market place, too. My own portfolio has a couple of short positions. In the long run, the truth will always come out." (Emphasis mine)
In the long run, the truth will always come out. Ultimately, that's what matters. All other responses from management - name-calling, defensiveness, etc. - suggest they are more focused on the short term than building a great business in the decades ahead. Just go out there and execute.
There's a reasonable case to be made that you should avoid investing in companies that might be the subject of a short report in the first place. Indeed, if there are some concerning risks at a company you're researching, it might be worth setting aside and focusing on a higher-quality idea.
That said, as Buffett put it, you pay a high price for a cheery consensus in the market. Opportunities are more often found in companies where there's currently debate and uncertainty. This group is more likely to attract short interest, so we shouldn't avoid companies that might have a short report written about them one day.
Instead, we need to roll up our sleeves and do the work. Expect - and welcome - some challenge to your thesis and see it as part of the learning process.