Legendary basketball center and power forward Moses Malone, who played in both the ABA and the NBA (he was the MVP of the NBA three times, including twice in a row in the '81-'82 and '82-'83 seasons) once said:
I didn't pay attention to the things people said about me. I didn't want to know what they were saying, because I figured I was the only one who knew the truth.1
This statement strikes us as one that is critically important in many spheres of life -- not only in sports but in investing as well.
In the world of investing, there will be times when an investor may feel as though he or she is "the only one who knows the truth." While it is probably not advisable to pay no attention to critical opinions about an investment, it is extremely important to realize that there will always be critical opinions, and it is extremely important to be able to determine when, like Moses Malone, one needs to have the confidence to proceed even if (especially if!) he or she is the only one who seems to know the truth at any given point in time.
While the subject does not always get much coverage in the "financial media," investors should realize that there are traders who make a living by purposely driving stocks down (typically by "shorting" the stock, among other strategies), and who may float negative stories in order to assist in driving stocks down for their own profit (and to the detriment of those companies and the investors who are "long" those stocks).
We are not suggesting that shorting in and of itself is nefarious -- in fact, we believe it is a valid trading strategy and serves to keep the managements of companies disciplined. Short sellers are often the first to uncover mismanagement or impropriety and act on it, providing a valuable check to market prices. We have written about this in the past (see here and here).
However, some short sellers and research firms which cater to short-selling hedge funds will craft carefully-written articles which paint legitimate accounting practices as underhanded forms of "cooking the books," with pages and pages of examples full of accounting jargon to back up their case, which can take days to sort through. When a story like this comes out, big investment firms that hold those stocks will often sell first and sort through the esoteric accounting allegations later, especially if the story is accompanied by a rush of selling.
To further exacerbate the impact of these hit pieces, and to help start the mini-panic in the stock, some short sellers may engage in the illegal (but difficult to stop) practice of "naked short selling," which is discussed in this Bloomberg News special report, which was nominated for an Emmy award for broadcasts which first aired between June 2006 and June 2007.
When such critics are at their most vicious, an investor in a stock under such an attack may watch a dramatic drop in the price, sometimes in a single day and sometimes over an extended period. In the words of another great quotation, by American patriot Thomas Paine, "These are the times that try men's souls." An investor in such a situation then has some hard work to do, to determine whether the criticism is valid, or whether those who are selling in a panic are wrong.
That there are investment firms out there who specialize in making money by producing negative reports that will drive down a stock in order to make money is evident from the facts presented in a case between Overstock.com and two different investment-related firms, which took place between 2005 and 2009.2 In that case, Overstock alleged that a hedge fund colluded with a paid research firm to publish negative reports about Overstock.
This discussion of some of the evidence presented in the court cases indicates that the research firm may have altered the reports to make them more negative at the request of their customers (who were often hedge funds shorting a stock), and that the hedge-fund customers of the negative research firm would even ask the research firm "not to disseminate the report to the public for a specified time period so they could obtain their position in the targeted company’s stock prior to the public receiving the information."
According to the testimony presented in the court cases, it also appears that the research firm would keep track of what they called "blow ups," defined as a stock-price drop of 20% or more in a single day, or 25% or more in a single week, and advertise their successful "blow ups" to potential or existing customers.
Both naked short-selling and deliberately misrepresenting the facts about a public company are illegal. However, both practices are very difficult to prove, and therefore very difficult to shut down. "Failures to deliver" can happen because of clerical errors, and in fact they do happen every day, without deliberate naked shorting involved (for more detail on this subject, watch the Bloomberg special report, or research the subject further on your own). Also, when a story is published on an investment news website which portrays arcane (but legitimate) accounting practices as being nefarious or illegal, it is very difficult to prove that the story was intentionally trying to mislead -- it is very easy to argue that the author thought something was wrong, and was using protected free speech to call attention to what they mistakenly thought was bad accounting.
Both naked short-selling and deliberately misrepresenting the facts about a public company are illegal. However, both practices are very difficult to prove, and therefore very difficult to shut down. "Failures to deliver" can happen because of clerical errors, and in fact they do happen every day, without deliberate naked shorting involved (for more detail on this subject, watch the Bloomberg special report, or research the subject further on your own). Also, when a story is published on an investment news website which portrays arcane (but legitimate) accounting practices as being nefarious or illegal, it is very difficult to prove that the story was intentionally trying to mislead -- it is very easy to argue that the author thought something was wrong, and was using protected free speech to call attention to what they mistakenly thought was bad accounting.
The court cases between Overstock and their adversaries were ultimately settled out of court. However, the information which surfaced during the cases should be understood by investors who choose to allocate capital to a company in the public markets. In this world, there will always be those with differing opinions, and there will sometimes be those who hold malicious opinions or who, for whatever reason, are actively involved in tearing someone or something down with their words.
A player in professional sports is familiar with such criticisms. In fact, during one's career, it is sometimes said that a player's "stock" is going up or going down. When critics were trying to tear down Moses Malone's personal "stock" as a player, he chose not to listen, figuring that even if he was the only one who knew the truth, he was going to eventually prove the critics wrong. Today he is considered one of the fifty best NBA players ever to have played the game.
Investors who venture out into the often-brutal world of the public markets should learn a lesson from this basketball legend.
1. Quotation from The Edge, by Howard Ferguson (1983), page 7-13.
2. At the time of publication, the principals of Taylor Frigon Capital Management did not own any securities issued by Overstock.com (OSTK), nor did they during any of the proceedings discussed in this post.