These ‘men without bowels’ are more likely to be the prompt discoverers of bad news than the inventors of it
No economist could remain unmoved by the brouhaha that has engulfed Herbalife, the nutritional supplements company. The sponsors of football teams such as Barcelona and LA Galaxy, it sells diet drinks and protein bars through a network of small distributors, many of whom recruit, train and supply further distributors. This may be an intelligent way of selling the product through word-of-mouth. But doubters wonder whether Herbalife isn’t too reliant on distributors filling their spare bedrooms with protein shakes, which they hope to sell at a profit by recruiting yet more distributors.
In May last year, a hedge fund manager called David Einhorn asked a few pointed questions on a Herbalife investor conference call, wondering how many final customers Herbalife actually had. Herbalife’s share price promptly fell by a fifth. Einhorn has a reputation as a savvy sceptic, and had made a very public bet against Lehman Brothers a few months before the company imploded. Another short-seller, Bill Ackman, recently took a large short position, and then argued at great length that Herbalife was a pyramid scheme. Herbalife denies this vigorously.
It’s not just Herbalife’s reputation that is at stake here: it’s that of short-selling, a practice that has been controversial since 1610, when it was banned, after somebody tried to short the Dutch East India Company.
The emotional case against short-selling was caricatured perfectly in Fred Schwed’s classic book, Where Are the Customers’ Yachts? “At the very moment we were buying that stock, hopefully and constructively, looking forward and upward toward better things, those fellows, men without bowels, were selling it and they didn’t even have it to sell!”
Short-sellers seem bad because they’re hoping for bad things to happen. Now this is true but irrelevant – unless the short-sellers cause the bad things to happen in the Wall Street equivalent of an insurance job. This has always seemed a risk for banks, because banks depend on the confidence of their funders. If it became widely believed that a particular bank would collapse tomorrow, the bank would collapse today. Perhaps short-sellers could destroy a bank, and profit from its destruction, simply by convincing others that the bank was doomed. Perhaps.
It’s even less clear that short-sellers can cause permanent harm by saying cruel things about a strong company. Herbalife should be at little risk – unless it really is a pyramid scheme, in which case a lack of confidence in its business model could become self-fulfilling. But while Ackman’s criticism did dent the company’s share price, the shares quickly recovered and it was higher at the start of this year than it had been two years previously.
Economists have long suspected that short-sellers are more likely to be the prompt discoverers of bad news than the inventors of it. And we now have some data. After the collapse of Lehman Brothers, many countries restricted short-selling – but at different times and for different classes of shares. Two economists, Alessandro Beber and Marco Pagano, used the variation produced by this patchwork response to filter out the impact of the bans. They concluded that the bans made stocks less liquid, slowed down the price discovery process and, mostly, failed to buoy prices.
In short, the bans were counter-productive. Several other pre-crisis studies reached similar conclusions.
Short-sellers have a powerful argument in their defence: who else has an incentive to spend millions of dollars uncovering frauds and letting the air out of bubbles? We could have done with more early scepticism of Enron and Bernie Madoff, of Wall Street, mortgage-backed securities and the dotcom mania. The “men without bowels” should be allowed to continue their dread work.
Also published at ft.com.