Imagine borrowing from someone else’s stockpile of corporate stocks, then selling shares, later buying them back and returning them, keeping any profit. That’s what short sellers do on a regular basis, and they tend to out-perform the analysts.
The practice is called short selling, and research by two Texas A&M University business professors and a former PhD student shows that ordinary investors can profit by trading with the short sellers.
Their research investigated whether short sellers and analysts differ in how they use information that predicts future returns. It appears short interest significantly anticipates the expected direction, while analysts tend to positively recommend stocks with high growth, high accruals, and low book-to-market ratios, despite these variables having a negative association with future returns.
“Investors frequently observe and use recommendations from analysts on whether to buy or sell a stock,” says accounting Professor Lynn Rees. “But, our research suggests that analysts do not always use accounting information, such as accounting accruals and cash flows, in forming their recommendations; whereas, short sellers appear to do much better in using these signals.”
Co-authors are Edward P. Swanson, holder of the Durst Chair in Accounting; and Mays doctoral graduate Michael Drake of BYU. The researchers have presented the paper to professionals, as well as academic audiences, and a NYC capital management company that uses short interest as an input in an investment model.
A low percentage of investors do short selling, but a very high percentage of investors would be interested in what they are doing, Rees says, because the short sellers tend to do better than the market. “Our evidence suggests that using the level of short interest combined with analysts’ forecasts allows investors to make more profitable investment decisions,” he says.
“Trading against the prophets: Using short interest to profit from analyst recommendations,” by Michael Drake, Lynn Rees and Edward P. Swanson, was published in The Accounting Review.