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John Engle
John Engle
Articles (529) 

Baillie Gifford Takes Aim at Stock Lending and Short Sellers

The asset manager is unconvinced of its value to price discovery

February 23, 2020 | About:

Short sellers are rarely popular. By nature, it is their job to rain on other investors’ parades, by exposing poorly reasoned public assumptions, interrogating questionable investment theses and holding dubious management teams to account. But short seller antagonism is not something to fear. Rather, it should be embraced by investors as a vital contributor to effective, efficient price discovery, as well as a tool for rooting out the worst excesses by corporate managers.

Unfortunately, a growing chorus of powerful financial and corporate actors has been increasingly vehement in its opposition to the practice of short selling. That is a worrying sign for the long-term integrity of financial markets.

The importance of price discovery

In capital markets, price discovery is critically important. James Chen of Investopedia has offered a short and useful definition of the process:

“Price discovery is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency.”

Today, public markets are awash with an ever-updating stream of data and information, all of which contribute to enhancing the price discovery process. This informational deluge has largely served to enhance capital market efficiency.

The swifter and more accurate the process, the more accurate the prices of traded assets.

The short seller’s role

Short sellers fill a very important role in price discovery. While the vast majority of financial analysts, commentators and media tend to be relentless cheerleaders for stocks and their stories, short-side analysts look to poke holes in those stories. By questioning narratives and digging deeper than long-side analysts and commentators are willing to go, short sellers can discover vital information about companies that might otherwise stay buried.

In recent years, shorts have been responsible for exposing many companies’ fraudulent or misleading practices. MiMedx Inc. (MDXG) offers one telling example. Legendary short seller Marc Cohodes spent years exposing the company’s highly questionable financial practices, which resulted in the ouster of a dubious management team.

One might think that improving price discovery would be welcomed by all financial professionals and asset managers. Alas, this is far from the case.

Baillie Gifford’s repudiation

Late last year, Japan’s massive Government Pension Investment Fund announced that it would no longer lend stocks in order to curtail borrowing by short sellers. While ostensibly an effort to act as a better steward of its constituents’ capital, the GPIF’s decision is a repudiation of short selling. That, as I explained in a recent article, is bad news for capital markets. If other big allocators were to follow the GPIF’s lead, it could have profound negative effects on the price discovery process.

Many influential voices have come to the GPIF’s defense. On Jan. 1, Charles Plowden, senior partner at Baillie Gifford, applauded the GPIF’s decision in unambiguous terms:

“What is the value created through stock lending? Those who defend the practice cite setting fair prices as an important outcome. But how valuable or helpful is this to the broader mission? Is such price discovery really helpful or necessary? There are increasing numbers of extremely successful companies growing to enormous size but opting to stay away from public markets that would disagree. So too would those family-controlled businesses, so numerous in Europe, that think in terms of generations rather than milliseconds. For many such companies, among which can be counted some of the very best long-term wealth creators, price discovery is an irrelevance.”

Lack of familiarity breeds contempt

Most big asset managers and pension funds rarely take the short sides of trades, meaning they have little practical experience with it. Moreover, since shorts tend to focus on a specific company, rather than a sector or industry, asset managers can feel themselves – or their long positions – threatened by unwelcome criticism.

As a result of this mixture of limited exposure and individualized grievance, many financial professionals (as well as the public company operators who come under direct fire) have come to share Baillie Gifford’s antipathy toward short sellers, and thus tend to discount the benefit of the practice to overall market health.

Curtailing the activities of short sellers is a bad idea for capital markets. Yet, with the post-Great Recession bull market still chugging along, asset prices continue to rise across the board. Inflated asset prices means inflated risk in the event of a fall. Animosity toward short sellers tends naturally to intensify under such circumstances.

Verdict

Burying one’s head in the sand may not hurt blue-chip asset managers, but it will hurt individual investors. Wise investors do not ignore or seek to silence critics. Rather, they listen closely and test all new facts against their existing thesis.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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