Think - AT LONDON BUSINESS SCHOOL

Go long to resist short selling

Donal Crilly says firms who adopt a long-term perspective can resist the short-termism pressures brought on by short sellers

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In 30 seconds:

  • Firms that are targets of short selling are vulnerable to predatory trading and stock-price risk
  • Intuitive response is to reduce investment to mitigate the downward pressure on stock price, which likely involves cost-cutting that negatively impacts employees
  • But attitude of key internal and external stakeholders is critical to successful response
  • If the decision-makers responsible for the allocation of capital are convinced of the link between employee wellbeing and long-term shareholder value, they will be better able to resist pressures arising from short selling.

The idea that firms facing market pressure from traders short-selling their shares sometimes respond by cutting corners on workplace safety may sound like something from a distant industrial past, but our research has found that this is indeed the case, and that such short-termism can increase industrial injuries at a firm by about 10%.

Not every corporation reacts in this way, however. We examine the reasons why some are able to maintain a long-term perspective, including in relation to workplace safety.

Traditionally, short sellers would take advantage of leisurely stock-market settlement periods, selling stock they did not own and buying it sometime in the future, ahead of the settlement date, at an anticipated lower price. Today, with much swifter settlement times, the process is enacted by the short seller borrowing the shares, selling them and then buying them at an expected lower future price to return to the lender.

Two facts emerge from this thumbnail sketch of short-selling. One is that there is no guarantee that the short seller has made the right call; should the share price rise rather than fall, the short seller will be out of pocket – caught, as the saying goes, in a bear trap.

The short seller therefore has a vested interest in the share price falling rather than rising. If the seller has analysed the company and concluded correctly that the stock is over-valued, events can take their course and a profit will be made.

But such a hands-off approach may not on its own yield fruit; in which case the short seller will need to take a more proactive role. This could involve attempts to uncover the sort of alleged corporate wrongdoing that, when made public, would be likely to adversely affect the share price, or it could involve disseminating negative information about the business calculated to depress its share price.

Responding to threat

In such a situation, the target company would be vulnerable to predatory trading and stock-price risk. How should it respond?

Intuitively, it might be expected to reduce investment to mitigate the downward pressure on stock price. But some studies suggest a different response to this pressure, with companies trying to improve employee relations, including by attending to safety at work. This would not be entirely disinterested, given that workplace injuries are the type of bad news that could depress the share price. Better treatment of employees would guard the firm against social risk.

Whatever the motivation, this does not form part of our argument, which is that short-selling pressure is likely to lead to neglecting the interests of non-shareholding stakeholders, and that one way in which this is manifested is a decrease in workplace safety.

Why would this surface at a time of pressure from short-selling? The short answer is that markets do not always immediately fully value stakeholder relationships. Sometimes, in fact, they do the reverse, when activist shareholders interpret excellent relations with stakeholders as a sign that the firm is insufficiently committed to shareholder value and allowing resources to leak into what are seen as unproductive activities relating to non-financial stakeholders such as employees.

Thus, for management, there is always a gravitational pull to prioritise short-term performance, but this is magnified when firms seek ways to avoid negative events, because potential losses, such as falling share prices, are more immediate and visible than potential gains, such as higher productivity, whose realisation may be more distant.

The price of short-termism

Unsurprisingly, given that short-selling pressure can give rise to short-term reactions, the response by the business concerned is itself time-sensitive. An obvious way to raise a stock price wilting under the glare of the short sellers is to focus relentlessly on short-term earnings.

To take just one example, Nobilis Health Corporation of Houston, Texas beat off short sellers by turning in quarterly earnings that topped estimates by more than 97%. As bear traps go, that is certainly impressive.

But such efforts to boost short-term results come at a price. They deplete the resources available for staff training and improved machinery. Cutting expenditures that can be seen as secondary or non-essential reduces employees’ opportunities to become better acquainted with safety policies and procedures.

Outdated machinery is more likely in such circumstances to be kept in operation, with obvious safety implications. Nor is it only such equipment that is in danger of being overworked. More limited resources raise the likelihood of employee burnout, leading to less care being taken and more injuries, and firms may also be tempted to go even further and impose heavier workloads. In all, the outcome is to deplete mental and physical strength, leading to more injuries.

The scale of workplace accidents in the United States is startling, even given that its 163.7 million-strong labour force is much larger than those of the other Group of Seven economies, which range from Japan’s 68.6 million to the UK’s 29.5 million people.

In 2016, according to the US Occupational Safety and Health Administration (OSHA), there were 5,190 fatal workplace injuries in the US private sector, and 2.9 million non-fatal injuries and illnesses. OSHA defines such injuries and illnesses as those that “result in days away from work, restricted work or transfer to another job” along with “loss of consciousness or medical treatment beyond first aid”.

The economic cost in the US of such injuries is $550 billion – the equivalent of 4% of global GDP.

But while pressure arising from short selling is, all things being equal, likely to produce a short-term response from the company concerned, with deleterious consequences for employee wellbeing, there is nothing automatic about this process. It depends on the nature, culture and structure of both the firm concerned and its external stakeholders. Some businesses contain built-in countervailing factors that can push back against such pressures; factors arising from the interests of stakeholders other than the short sellers.

One such stakeholder is the company’s senior management, the decision-makers responsible for the allocation of capital. Should they be convinced of the link between employee wellbeing and long-term shareholder value, they will be better able to resist pressures arising from short selling.

‘The attitude of key stakeholders is critical in determining whether the firm embraces the sort of response that can increase injury and illness’

Union power

Elsewhere in the business, employees themselves comprise a stakeholder group; one whose bargaining power is bolstered by the presence of strong trade unions. Not only can unions monopolise the labour supply, they can threaten industrial disruption if workplace safety appears to be compromised. In this way, the potential cost of employee injuries for the company is raised and the managers are disincentivised from implementing the sort of measures that may lead to an increase in such incidents.

Not only does union representation limit the ability of executives to formulate short-term responses to market pressure, but a history of dialogue between management and unions, fostering a collaborative approach to problem-solving, should provide an institutional bulwark against the adoption of such responses.

Stakeholder attitudes are key

Outside the business, the attitude of two further key stakeholders will be critical in determining whether the firm embraces or shuns the sort of response that can increase injury and illness in the workplace.

The first comprises the firm’s investors. Dedicated institutional investors with a long-term focus provide a double benefit for the company. The first is that their presence on the share register makes it less likely that the stock is mispriced, reducing the scope for short selling.

The second is that they are more likely to give priority to long-term performance, reducing the need for managers to respond to short-selling pressure.

A second important external stakeholder is made up of the investment analysts who follow the company’s fortunes and advise investors and fund managers accordingly.

While pressure from analysts is often seen as contributing to short-termism, there are analysts who take a longer view and have a better understanding of future growth prospects; an understanding that can be reflected in the share price.

Ultimately, the nature of corporate responses to short-selling pressure will depend to a great extent on the outlook and reaction of these four key stakeholders.

Donal Crilly is Professor of Strategy and Entrepreneurship at London Business School

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