When investors employ a short-sale strategy – essentially betting that a stock’s price is due to decline – they should expect higher returns when there’s the possibility that the company may be targeted for a takeover, research by the finance department’s Costanza Meneghetti reveals. The findings point to previously unidentified tensions in market governance forces.
The research, “The Market for Corporate Control as a Limit to Short Arbitrage,” found that the motivations of short-sellers and bidding firms when targeting overvalued stocks often conflict. That conflict leads to inefficiencies in the marketplace. Where short-sellers target stocks that are overvalued and hope to profit when prices naturally correct, bidding firms hope to acquire a mismanaged firm and fix its performance. When they do, they tend to pull stock prices higher.
“The dynamics are short sellers target companies that are overvalued and mismanaged,” Meneghetti said. “When they do that, then the price of their target stock starts going down. Then, as the price goes down, it becomes easier for an acquirer to try a takeover attempt. If the target is acquired, then the price of the target stock shoots up and damages short sellers.”
Because of this dynamic, researchers argue that as takeover possibilities increase, traders taking short positions are more at risk for losses. Thus, they seek higher returns for their trades when a firm may be targeted by corporate raiders. The findings were published by the Journal of Financial and Quantitative Analysis.
“The Market for Corporate Control as a Limit to Short Arbitrage”
Costanza Meneghetti, Ryan Williams1, Steven C Xiao2
Journal of Financial and Quantitative Analysis
1 Groupede Formation et de Rechercheen Finance,Université ParisDauphine – PSL
2 University of Texasat Dallas Jindal School of Management
Short sales 101
On its surface, taking a short position on a security is a straightforward transaction. Investors borrow a stock through a broker, which is immediately sold at the current market price. In the future, when the stock value drops, those investors buy back the amount of lent stock and return it, profiting on the difference between the two price points.
Logistically, it gets much more complicated. Broker fees eat into profits, and margin calls make short positions inherently risky – in addition to all the hazards of the market itself. Because of the complexity, it’s a strategy typically employed by financial professionals.
“We consider them informed players or informed investors compared the average retail stock investor,” Meneghetti said. “That’s their livelihood. They know the risk and they make their choices accordingly.”
Movies such as The Big Short and Dumb Money frequently make short-sellers out to be financial pirates siphoning wealth against the vested interests of traditional investors, but they actually perform essential governance on the market, helping ensure stock prices accurately reflect firm value to investors.
Mining troves of historic data
The paper digs deep into historic market data to draw its conclusions. Researchers identified a pool of 8,932 common stocks traded between 1984 and 2018, eliminating small stocks and those that were previously targeted for takeover. Among these, they analyzed each stock’s potential for takeover based on trends in its industry and its interest to short-sellers, measured by the number of shares shorted as well as the number of each stock’s shares available for lend through brokers.
Using this data, Meneghetti and her coauthors performed univariate analysis using value-weighted portfolios and multivariate regression analyses. They also controlled for short-selling costs and the availability of lendable shares. The researchers discovered that the threat of a takeover bid is seen by short-sellers as an additional risk and that short-sellers therefore require a higher return when taking short position in stocks that face higher takeover risk.
“What I find interesting is that nobody really realized that the interaction between the two actually creates an inefficiency that emerges naturally,” Meneghetti said. “It’s just a matter of incentives, and one thing actually we show towards the end of the paper is that there is more mispricing because of that.”
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