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Robert Hagstrom is a portfolio manager with a flair for narrative. Principal of the US$1.06 billion Legg Mason Growth Trust, a fund based in Baltimore, he’s written several bestsellers, which include The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor. On April 28, he gave a talk at the Society of American Business Writers’ and Editors’ Conference, also in Baltimore. Hagstrom sketched out a compelling account of the rollercoaster ride global markets have been on since heading into the credit crunch last July. It culminated, he argued, in the run on Bear Stearns in March. It was almost as if players needed a ritual sacrifice before markets could get past their winter of discontent.
“Since the Bear bailout, credit spreads have steadily improved,” said Hagstrom. “As long as spreads continue to narrow, stocks should as well. And equities are not over-valued.” He pointed to low price-to-earnings ratios on such stocks as Nokia and Cisco. (Full disclosure: both Nokia and Cisco are in Hagstrom’s top ten holdings.)
Hagstrom’s in good company: U.S. investors Kirk Kerkorian and Warren Buffett also think now is the time to buy. In late April, both announced significant new investments in American icons Ford and Wrigley, respectively.
Later in his talk, Hagstrom touched on Bear again, this time in reference to the U.S. Securities and Exchange Commission’s newfound interest in the role short sellers may have played in exacerbating Bear’s meltdown. “What we’re now seeing is a spike in the number of fund managers being investigated by the SEC for market manipulation,” he said. Investigators have requested emails and text messages from fund managers, looking, Hagstrom said, for evidence of irresponsible rumour-mongering—a practice known as short-and-distort, in which short sellers borrow and sell a stock at a high price, then send out a report, email or text message questioning the company’s fundamentals and/or its liquidity, in order to drive down the price. They then re-acquire the stock at its lower valuation and pocket the difference. Such rumour-mongering—particularly when a company’s basic liquidity is in question—is, Hagstrom said, akin to “yelling fire in a crowded theater. Anyone out there bull-shitting, be warned.”
When asked to confirm whether or not the SEC is conducting a probe into the relationship between short-selling activities and Bear Stearn’s demise, SEC spokesman John Heine said he was not sure what he was authorized to say, and subsequently could neither confirm nor deny that an investigation is ongoing. Meanwhile, on April 24, the SEC accused ex-trader Paul Berliner of using instant messaging to manipulate the stock prices of Alliance Data Systems Corp., a provider of customer loyalty programs.
It’s true the shorts have been making money off the markets’ wild ride. U.S. financier John Paulson’s fund is up US$15 billion in 2007, after he decided to short sell financial stocks prior to the sub prime blowout. Paulson himself is estimated to have raked in between US$3 billion and US$4 billion. At a time when millions of dollars have evaporated, market players are looking for someone to blame. Those who appear to be profiting off others’ pain make an obvious target.
What’s more, blaming the shorts for market disaster is nothing new. After the 1929 market crash, captains of industry complained short selling had fuelled the crash, and legislators passed laws reining in the practice. But here’s why, for those hoping to resolve fundamental problems in the financial markets, blaming the shorts for profiting off managers’ and investors’ poor decisions is more of a distraction than a solution.
Short sellers provide liquidity. There’s always got to be someone on the other side of the trade. More importantly, short sellers’ activity tempers what former U.S. Federal Reserve chairman Alan Greenspan once referred to as “irrational exuberance”—in which stock prices appear to bear no logical relationship to the company’s earnings. The short senses a bubble in a company’s stock, investigates it, takes a short position if he or she thinks the stock is overvalued and/or the business model unsound, and profits when the stock price comes back to earth.
According to a proxy circulated to shareholders on April 24, at 2007’s fiscal year-end, Bear Stearns owned US$11.1 billion in tangible equity capital supporting US$395 billion in assets. That’s a gross leverage ratio of more than 32 to one. Blaming short sellers for betting against such a precarious business model does not a smart investor (or manager) make.
By watching smart short sellers take positions, investors can learn not to throw good money after overvalued business propositions—and focus their attention on less-trendy stocks with solid fundamentals instead. Consider this: on March 17, while U.S. markets were going dizzy over Bear Stearns, Canadian tycoon Seymour Schulich quietly increased his stake in Birchcliff Energy to 18%. Birchcliff is a junior oil and gas exploration outfit based in Calgary. Since debuting on the TSX in 2005, its stock has been on a steady upward trajectory.
Schulich knows that in markets where fear has driven too much decision making for too long, value plays are most certainly to be had. Silencing the shorts, however, will not make it easier for investors to find them.
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