In placing stock bets, listen to the shorts: study

NEW YORK Thu Feb 10, 2011 3:35pm EST

Floor Governor Rudy Mass calls out a price prior to the IPO of NeoPhotonics on the floor of the New York Stock Exchange, February 2, 2011. REUTERS/Brendan McDermid

Floor Governor Rudy Mass calls out a price prior to the IPO of NeoPhotonics on the floor of the New York Stock Exchange, February 2, 2011.

Credit: Reuters/Brendan McDermid

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NEW YORK (Reuters) - The average stock investor could be forgiven for being overwhelmed by opinions, but one study says if there's one group to listen to, it's the short-sellers.

Professors at Texas A&M and Ohio State universities concluded that following contrarian investors is more profitable for stocks in which analysts and short sellers strongly disagree.

In other words, buy if short interest is low and the analyst consensus is to sell; sell short if short interest is high and the analyst consensus is to buy.

In a short sale, an investor borrows shares in the hope that the price will decline, allowing the shares to be sold while the price is high and then bought back at a lower price to repay the loan.

The results showed a 1.11 percent average abnormal return per month over the course of 13 years, amounting to an average abnormal yearly return of more than 14 percent.

"You don't really want to ignore the analyst recommendations, but you are really sort of using them in not a very positive way," said Edward Swanson of the Mays Business School at Texas A&M.

"Essentially, the short sellers are doing a tremendous job of using information with predictive value, and they really look like value investors."

Some investors agreed with the results, as the increased risk taken by short sellers with their own capital makes them more active in rooting out potential problems in a company.

"For the most part Wall Street analysts are just cheerleaders, so they kind of go with the flow and if the stock is trending higher they raise their price targets and say good things," said long-time short-seller Bill Fleckenstein, president of Fleckenstein Capital in Seattle, Washington.

"That is not to say that analysts are always wrong and the short sellers are always right. But at the margin if it gets pretty lopsided, I would go with the short sellers."

But the point of analyst research isn't to solely point out whether to buy or sell stocks, said Michael E. Hoffman, director of research at Wunderlich Securities in Baltimore.

"It's very easy to take shots at the sell side isn't any good at picking stocks -- I would suggest that isn't what the sell-side gets paid for," he said.

"The sell-side research value-add is to be an unequivocal expert in the subject matter, to have unrivaled access to information sources that you then provide a high quality, relevant, thought-provoking filter to the buy-side."

Swanson conducted the study with his Mays colleague Lynn Rees and Michael Drake of the Fisher School at Ohio State University.

(Reporting by Chuck Mikolajczak; Editing by Leslie Adler)

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