Not Everyone Thinks Short Selling is Dead

Bucking the trend of negativity, fund manager Chris Brown still thinks a huge market “blow-off” is in the offing.

(Alex Kraus/Bloomberg)

(Alex Kraus/Bloomberg)

At least one hedge fund manager says short selling is still alive and well.

Following a month when members of a Reddit forum pushed heavily shorted stocks sky high and pilloried short sellers in the process, many of them have bemoaned their fate and worried about the future.

But not Chris Brown, founder and managing member of Aristides Capital, which runs a long-short strategy. Aristides’ short book — which includes names like GSX Techedu, the Chinese online educator, and Cel-Sci, a biotech company — certainly hurt its performance last month.

Aristides’ main hedge fund ended the month with a loss, down 3.64 percent, and a separate quant strategy didn’t do much better. It fell 3.60 percent.

But Brown is sanguine. “Long story short: we survived this crisis,” he wrote in a January 31 letter Institutional Investor has obtained.

Brown noted that investors have been asking, “Will current events change shorting forever?”

“I don’t think so,” he said. “There’s quite a lot of dumb money flowing into certain corners of the market, and there will be for the foreseeable future.”

“Although pockets of the market have been insane lately, and sentiment has gotten overstretched,” he continued, “it’s doubtful that financial conditions can be this loose without it eventually bringing about a huge blow-off top.”

By the end of January many hedge funds had taken off their short positions, which means “there are fewer stocks where short interest is egregiously stretched,” he said. As a result, he argued, “I doubt we’ll see quite a ‘flow-pocalypse’ into garbage equities at quite the [same] pace.”

But there was no way to avoid the rout that began with January’s Reddit-engineered short squeeze in GameStop, which led to similar action in other names hedge fund Melvin Capital was short. In his letter, Brown laid out how he defended against the short squeeze in two of his shorts.

One of them was Melvin Capital short GSX, which Brown said was “unfortunately a favorite short of ours as well.”

As early as January 13, Brown said he realized what was happening, “and reduced our exposure to GSX as a result.” But he said the fund “kept on a substantial portion of our position, as (1) we like GSX as a short; even if 70 percent of its revenue weren’t fraudulent, the stock was trading at 12x this year’s revenue with net margins of negative 20 percent, and (2) most of our position was structured as put spreads, meaning the most we could lose on those positions was 100 percent, rather than the 200 percent plus loss a straight short would have incurred,” he explained.

GSX has denied short sellers’ accusations that its revenues are fraudulent.

But Brown admitted he didn’t trim some of his shorts “nearly fast enough.”

For example, Brown covered about one-third of its short in biotechnology company Cel-Sci prior to the squeeze. “I hated doing that; while the company has completed its almost certainly-failed phase 3 trial, it has been sitting on the data for months now, and once they release the data and it becomes apparent that their drug does not work, the stock will almost certainly collapse,” he told investors.

In its fiscal 2020 yearend report on January 11, Cel-Sci said the release of the trial results “has been complicated by both the geographical diversity of trial sites and delays related to the pandemic.” It promised to publicize the results once the full analysis has been finalized and results are presented to the firm. Cel-Sci did not immediately respond to a request for comment.

In the meantime, Brown said, “I knew looking at the chart that the stock might have a technical breakout soon, and I figured if it started to break out, I would cover another 1/3 of our short position. I didn’t anticipate the breakout occurring as fast and sharp as it did.”

The stock went from $15 to $40 in one day “on no news whatsoever, except for the company’s CEO tweeting at serial SPAC sponsor and pseudo-populist billionaire Chamath Palihapitiya.”

[II Deep Dive: Hindenburg Research Goes After ‘Wall Street Celebrity Promoter’ Chamath Palihapitiya]

“In a matter of minutes, Redditors were trying to make it the next GameStop,” he said. “Afraid the stock might double yet again, I covered more of our … position at horrific prices, and we ended up losing 119 [basis points] on that position this month.”

Brown noted that “it wasn’t just Redditors and bored retail investors gunning at shorts…. The retreat of long-short funds themselves contributed a great deal to the price action.”

In anticipation of a short-term correction around the GameStop fracas, he said the fund lowered net exposure into the low 40s. But once the correction was over, he anticipated looking for ways to increase the fund’s net exposure.

“It’s not that ‘things are different this time’; they will likely end the same way that speculative booms always do; but we probably aren’t at the end yet,” he surmised. “So long as liquidity flows into the system, stimulus continues, and consumer balance sheets remain strong, equities will likely continue to go up.”

Brown also predicted there would not be “serious negative legislative/regulatory change as the result of what happened.” He praised Senator Elizabeth Warren’s take on the situation, saying that among lawmakers, she “has had the most sober view of events, and she understands the importance of a well-regulated financial system better than most.”

“It seems unlikely that the same misunderstandings (no, brokers did not change the rules in the middle of the game in order to help hedge funds) and populist fervor that has infected much of the discourse … will be successful in infecting the minds of 60 Senators,” he concluded.