OWNERSHIP STRUCTURE, EXPECTATIONS, AND SHORT SALES ON THE NASDAQ

Journal of Economics and Finance, Spring 2007 by Graham, J Edward, Hughen, J Christopher

If institutional ownership affects firm performance, then it should influence the level of short selling. McConnell and Servaes (1990) document a positive relation between Tobin's Q and institutional ownership. The authors argue that this finding is consistent with these investors providing valuable monitoring at a low cost. As this efficient monitoring may result in greater future earnings, a high Tobin's Q does not necessarily signal an overvalued stock. Han and Suk (1998) address this issue by examining the contemporaneous relation between stock returns and ownership structure. Their study concludes that higher institutional ownership is associated with higher stock returns.

Inside Ownership

Morck et al. (1988), McConnell and Servaes (1990), and Han and Suk (1998) find that corporate valuations peak at high levels of inside ownership. The complex relation between insiders and valuation is related to the following factors: the convergence of interests between shareholders and managers as inside ownership increases, the entrenchment of management with higher ownership, and the connection between stock remuneration and firm performance. Since inside ownership impacts stock prices, this factor likely affects the level of short sales.

The amount of inside ownership may also affect the observed level of short-selling activity by influencing the availability of shares for borrowing. Publicly-traded companies have formal insider trading policies that often prohibit insiders from holding shares in margin accounts.3 Such policies not only prevent insiders from having to unexpectedly sell their stock due to a margin call, but also take these shares out of the pool of available shares for borrowing. Thus, the cost of borrowing stock may increase with inside ownership.

Insiders that hedge their ownership positions may indirectly affect the level of short interest. Bettis et al. (2001) find that insiders often use derivatives such as collars and swaps to hedge on average 25% of their stock exposure. The institutions (often commercial banks) that facilitate these transactions may hedge their positions by shorting stock.

Financial Ratios

Lakonishok et al. (1994) and Fama and French (1995) find that financial ratios predict future stock returns. Through an examination of monthly short interest figures, Dechow et al. (2001) test whether short sellers use this information in selecting stocks. They consider financial ratios such as cash-flow-to-price, earnings-to-price, book-to-market, and value-to-market. Changes in short interest indicate that short sellers consider fundamental analysis when initiating positions, and tend to cover their short sales when these ratios return to regular levels. Short sellers avoid companies that have temporarily low accounting figures and instead concentrate on firms that have high market prices.

Stock Liquidity and other Factors Influencing Short Sales and Subsequent Returns

Several studies find that short sellers pursue strategies involving more liquid stocks with lower transactions costs. Dechow et al. (2001) reach this conclusion using the market value, institutional holdings, number of institutional owners, and dividend yield as proxies for such costs. Kadiyala and Vetsuypens (2002) find that short interest responds positively to the improved liquidity associated with stock splits. The relatively liquid stocks will trade at a premium and have lower future returns. Empirical studies by Brennan and Subrahmanyam (1996) and Brennan et al. (1998) illustrate this relationship. Baker and Stein (2004) extend this research through a model that incorporates short-sales constraints and a class of investors that underreact to information in order flow. In such an environment, high levels of liquidity reflect positive sentiment by irrational investors and overvalued stocks. Work by Duarte et al. (2006) portrays the unattractiveness of short selling less liquid stocks, though they confess that "low observed short interest level[s]" cannot be "fully explained by the liquidity events" (such as short squeezes) confronted in some short sales. They underscore the costliness of using options to hedge short-selling losses.