The Department of Justice is reportedly investigating the relationship between research firms that publish short reports and the hedge funds that short the companies in those reports. However, many hedge funds are holding their ground as the investigation proceeds, and they continue to issue short reports and act upon them.
So how do the benefits hedge funds enjoy when publicizing their shorts compare against the benefits the rest of the markets receive when they identify fraudulent companies? Let\’s take a look at how research firms serving hedge funds have done with their short calls this year and at whether the market benefits from these reports at all.
Hedge funds continue to short despite reported DOJ probe
Hedge funds that issued short reports earlier this month have done quite well, sending the shares of the companies they uncovered into a tailspin. Ivan Cosovic of Breakout Point offers some highlights of December\’s haul for short-sellers in an email.
\Eleven stocks were added to short sellers\’ naughty list in December,\ he said in an email. \The most active was Kerrisdale Capital with three new short calls and corresponding average shares decline of 12.5%, while the most successful was Spruce Point Capital. Spruce published on Nuvei, and shares hit -40% price target within only few hours of report publication.\
Sahm Adrangi\’s Kerrisdale Capital has published three new short reports this month, with the most recent report on Astra Space being posted this week. The other two shorts are HubSpot
Kerrisdale says Astra Space is a space launch company formed at the height of the SPAC bubble earlier this year and has no revenue, no reliable track record and no established market for its \undersized vehicle.\ The firm believes Astra is a \story stock that\’s yet another example of the questionable businesses going public via SPACs.\ Kerrisdale also feels Astra is poorly positioned in an overcrowded market and that its primary competitors will soon launch larger payload rockets while it continues to struggle to overcome major developmental hurdles.
Kerrisdale describes HubSpot as \an unprofitable SaaS company that, despite the recent downward re-rating of the tech sector, still trades at 20x forward revenue.\ The firm believes HubSpot is a COVID beneficiary whose growth will ultimately disappoint.
Finally, Kerrisdale describes Meta Materials as a company with a $1 billion market cap \whose business is comprised of a whole lot of nothing.\ The firm also feels Meta Materials is a collection of failed lab experiments.
Spruce Point\’s short of Nuvei
In its short report about Nuvei, Ben Axler\’s Spruce Point said it believes the \highly promoted payments processing technology company has covered up a patter of business failures, lack of organic growth and a web of relationships with individuals connected to major Ponzi Schemes and alleged fraudulent activities.\ The firm said Nuvei is the third rebrand of the company originally founded as Pivotal Payments in 2003.
According to Spruce Point, the company is \reporting remarkable financial success, wildly expanded margins at its European targets, and cash flow after years of operating in the red.\ However, it believes Nuvei is under pressure after organic declines in North America. Spruce Point also believes the company\’s financial disclosures are weak and that its results \are being temporarily enhanced from concentrated exposure to high-risk gaming and eCommerce.\
Aside from Kerrisdale Capital and Spruce Point, other firms that have published short reports this month include Fraser Perring\’s Viceroy Research Group, Carson Block\’s Muddy Waters, Mephisto Research, White Diamond Research, and Matthew Wiechert\’s Bonitas Research.
This year\’s most successful short-sellers
Breakout Point also provided data on this year\’s most successful short-sellers year to date. Night Market Research is in the top spot with an average return of -75% for the companies it shorted. This year\’s reports included updates on Zynex and FuelCell Energy
While Night Market Research did not make Breakout Point\’s list of the top 10 most successful short calls of 2020, many of the firms on this year\’s list are regulars. Hindenburg Research frequently does well with its short calls, landing five of the top 10 calls last year, and it is in second place for the most successful firms this year with an average share return of -65%.
\Overall, a great year for activist short sellers,\ Cosovic said in an email. \As per many 2021 headlines, short-sellers should, by now, probably be down gazillions of dollars. However, short-sellers saw stocks they publicly talked about decline [an] amazing 42% on average (if all major short calls from period Jan-Nov are observed).\
According to Breakout Point, Night Market Research also had two of the top 10 best short calls with Mountain Valley MD and BeyondSpring. This year\’s other top calls include Bonitas\’ call on Ageagle Aerial Systems, Wolfpack\’s call on Chinese firm EHang Holdings, and Hindenburg\’s and Culpers\’ calls on the Chinese firm Sos Ltd.
Lesson in Luckin Coffee
Last year\’s list of the top 10 calls included the Chinese coffee shop chain Luckin Coffee, which three different firms reported on: J Capital Research, Muddy Waters and Ash Illuminations Research. Bloomberg reported that Luckin Coffee is one of the targets being reviewed by federal prosecutors investigating the relationship between research firms that publish short reports and hedge funds.
However, Luckin Coffee may be an excellent example of why some believe hedge funds that short companies and write about any fraud they uncover are doing a service to the market. Muddy Waters accused the company of inflating its revenue.
Two months later, Luckin Coffee itself reported the discovery that its chief operating officer and other staffers had fabricated about 40% of its revenue in 2019. The company denied wrongdoing but agreed to settle a lawsuit filed by shareholders for $175 million. It also settled charges filed by the Securities and Exchange Commission by paying a $180 million fine.
How hedge fund shorting has a place in the market
There\’s no denying that hedge funds that publish reports on the companies they\’re shorting make significant amounts of money off those reports. So how does one weigh the benefit for the market versus the benefit received by the hedge funds when they publicly report one of their shorts?
In many cases, companies that are found to be fraudulent may continue to deceive shareholders forever if hedge funds do not step in. Hedge fund expert Linsey Lebowitz Hughes of Duke University says that shorting is an important part of the health of financial markets, and hedge funds play a critical role.
\Hedge funds that uncover shortcomings in companies and short stocks provide a valuable service to the markets by \’outing\’ companies who are not running sound businesses,\ she said in an email. \They also provide a valuable service by taking the opposite side of (long) trades, providing needed liquidity to the markets. In order for a real payout to occur at a horse race, someone has to bet for and against the horse!\