“Short sellers play a valuable role in keeping stocks from becoming overvalued. ”
Certain stocks are likely to fall in coming months even if the overall market rises.
According to a study published this summer in The Review of Financial Studies, these vulnerable stocks are the ones that are most difficult to borrow and then sell short.
Entitled “The Dynamics of Disagreement,” the study was conducted by three finance professors: Kent Daniel of Columbia Business School, Alexander Klos of Germany’s Kiel University, and Simon Rottke of the University of Amsterdam. (Daniel used to be Goldman Sachs’ co-chief investment officer.)
The professors’ theory is that short sellers play a valuable role in keeping stocks from becoming overvalued. When something gets in the short sellers’ way — such as when it’s hard to find shares to borrow in the share-lending market, or when the cost of such borrowing is prohibitively high — then the shares in question will trade at a higher valuation than other stocks that are relatively easy to sell short.
The professors analyzed hard-to-short stocks over many years through 2020, finding that they significantly underperformed the market. Since their study first began circulating in academic circles, I have devoted four columns to their research, in each of which I published a list of hard-to-short stocks that their research predicted were most vulnerable to falling. The table below presents the results, which can be considered out-of-sample tests of the professors’ findings.
| Publication date of column | Average return over subsequent 12 months — or for bottom two rows, annualized returns through Nov. 29, 2023 | Comparable total return of S&P 500 | Extent to which stocks underperformed S&P 500 (in percentage points) |
| Aug. 18, 2021 | -16.6% | -1.2% | 14.4 |
| Jun. 15, 2022 | -22.0% | 18.7% | 40.7 |
| Dec. 26, 2022 | -7.4% | 21.8% | 29.2 |
| Jun. 20, 2023 | -20.1% | 10.1% | 30.2 |
The table at the end of this column applies the professors’ methodology to stocks in the S&P 1500 index. You’ll notice that the table is divided into two groups: “Constrained Winners” and “Constrained Losers.” Both groups contain those stocks that, per the professors’ methodology, are currently relatively hard to sell short — constrained, in other words.
The “Constrained Winners” group contains those with the best trailing-year returns, while the “Constrained Losers” group contains those with the worst trailing-year returns.
The stocks in each group are likely to underperform the market over the coming year, though for different reasons. In the case of the “Constrained Winners,” the dearth of short sellers leads the stocks to overreact to good news, Daniel explained in an interview. With “Constrained Losers,” in contrast, the relative scarcity of short sellers leads the stocks to underreact to bad news.
Should you short difficult-to-short stocks?
One obvious implication of this research is that you should avoid stocks that are “Constrained Winners” or “Constrained Losers.” Another would be to sell the stocks short — notwithstanding the relative difficulty in doing so.
Is that a good idea? That depends on several different factors, Daniel said. One is your willingness to stick with the short sales through possible intervening periods in which the stocks shoot up in price — during a short squeeze, for example. These price runups will require you to deposit more money with your broker as collateral, and if the runups are large enough this requirement could become intolerable. As John Maynard Keynes famously reminded investors a century ago, markets can remain irrational longer than you can remain solvent.
Another factor is how much you will have to pay to borrow shares in the share-lending market in order to sell them short. High borrowing costs will eat away at the theoretical gain you would otherwise realize by selling those stocks short.
This may not be a particularly big problem in practice. Daniel calculated the borrowing cost over the last year for those “Constrained Winners” stocks in my listing from a year ago, and found that they averaged 61 basis points. Since these stocks lagged the market by nearly 30 percentage points, the cost to borrow doesn’t come close to overcoming the theoretical advantage of selling them short.
Is there another catch? Daniel concedes that there always is the risk that as more of Wall Street discovers the value of his research, too many investors will start shorting these stocks and thereby “kill the goose that lays the golden egg.” That’s a concern with any market-beating strategy, of course. But, for now, as is clear from the data, there doesn’t appear to be any diminution in its effectiveness.
| CONSTRAINED WINNERS | ||
| Company/Ticker | Market Cap ($ billions) | 12-month return |
| Super Micro Computer, Inc. (SMCI) | 15.33 | 214.4% |
| Dorian LPG Ltd. (LPG) | 1.69 | 149.4% |
| HCI Group, Inc. (HCI) | 0.72 | 133.9% |
| Sotera Health Company (SHC) | 3.84 | 70.5% |
| Amphastar Pharmaceuticals, Inc. (AMPH) | 2.67 | 89.7% |
| R1 RCM Inc (RCM) | 4.49 | 29.8% |
| Celsius Holdings, Inc. (CELH) | 11.72 | 47.7% |
| Core & Main, Inc. Class A (CNM) | 5.96 | 68.2% |
| Royal Caribbean Group (RCL) | 27.14 | 76.7% |
| Alpha Metallurgical Resources, Inc. (AMR) | 3.66 | 67.9% |
| United States Steel Corporation (X) | 7.94 | 39.2% |
| Otter Tail Corporation (OTTR) | 3.11 | 30.1% |
| CONSTRAINED LOSERS | ||
| Company/Ticker | Market Cap ($ billions) | 12-month return |
| Moderna, Inc. (MRNA) | 30.13 | -54.4% |
| 3D Systems Corporation (DDD) | 0.71 | -42.3% |
| Agiliti, Inc. (AGTI) | 1.08 | -48.1% |
| AdaptHealth Corp. (AHCO) | 1.21 | -58.5% |
| Cytek Biosciences, Inc. (CTKB) | 0.93 | -43.3% |
| Harmony Biosciences Holdings, Inc. (HRMY) | 1.72 | -48.8% |
| Vir Biotechnology, Inc. (VIR) | 1.32 | -64.0% |
| Digital Turbine, Inc. (APPS) | 0.50 | -71.0% |
| Enphase Energy, Inc. (ENPH) | 13.79 | -66.7% |
| Lumen Technologies, Inc. (LUMN) | 1.36 | -75.3% |
| Clearfield, Inc. (CLFD) | 0.40 | -79.0% |
| SunPower Corporation (SPWR) | 0.75 | -81.6% |
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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