GameStop’s short squeeze in early 2021 drew attention to a class of short sellers who launch high-profile public short campaigns (PSCs) to drive down a target company’s stock. These militant short sellers, unlike traditional short sellers who often keep their short positions private, publicly denounce their targets and present evidence of specific allegations, such as accounting irregularities and product defects, or they may simply allege that a target’s stock is overvalued.
The growing importance of these activist short sellers is sparking debate about the roles they play in the financial market. Critics and, in particular, management targeted by ESPs have accused these activists of manipulating markets, spreading lies and causing long-term economic damage to target companies. For example, when several activist hedge funds announced their short positions in Tesla shares, Tesla CEO Elon Musk accused them of fabricating rumours, calling them “value destroyers” that steered the company away from the creation of long-term value.
Do ESPs Really Harm Target Businesses? In a recent study, we seek to answer this question by examining whether PSCs affect significant business innovation, using a new dataset of new product and service announcements from Capital’s Key Developments Database. IQ. Even after accounting for the possibly superior stock-picking abilities of activist short sellers, we find that PSCs significantly reduce the new product introductions (NPIs) of their targets. Using a sample of 274 PSCs announced over the 2010-2017 period targeting companies headquartered in the United States, Figure 1 below shows that target companies experience larger declines in adjusted NPI per year ( a company’s annual NPI minus its average over all years) compared to monitoring companies up to five years after the PSC announcements. Moreover, the results of our difference-in-differences regressions show that, relative to their matched control firms, PSC target firms introduce 11.2% fewer new products per year, on average, after being targeted. . The negative impact of CSPs lasts for up to five years after the campaign announcement, indicating that the product market impact is not transitory. Additionally, the target firms experience long-term declines in innovation productivity as well as product quality.
Figure 1. Adjusted average number of target companies and control of number of new product launches surrounding short campaign public announcements by year versus campaign announcement
We find that the decline in product innovation is partly due to key stakeholders withdrawing support from the target company. The negative publicity surrounding the target companies during the PSC negatively affects stakeholders’ perception of the target company’s future products. In our analysis, we consider three types of key stakeholders that are integral to the innovation process: capital providers, customers, and employees, and we find that the negative impact of CSPs on products is particularly significant among companies most vulnerable to declining support from these three types of stakeholders. Specifically, the decline in product innovation is particularly strong among firms with financial constraints and firms with weaker customer and employee commitments. Additional results show that targeted companies reduce the capital they raise and have poorer relationships with their customers after being targeted. Shareholder support for top management proposals at annual meetings is also declining. The sales of the target firms to their main customers decrease considerably compared to the control firms, and the rival firms of the targets benefit from an increase in the production of products.
We rule out several alternative hypotheses. We find that target firms’ product problems cannot be explained by target management making short-sighted cuts in innovation investments to boost short-term performance in defense against CSP. Additionally, we carefully consider the selection problem where activist short sellers may be able to detect target firms with future product innovation problems that are not observable in the general market. Using Heckman’s two-stage selection model and a strong instrumental variable, we find that target firms continue to have problems with their products. So, while selection may partially determine outcomes, it cannot be the only reason.
Our article has several important implications. First, it outlines the difference between public short selling and undisclosed traditional short selling and suggests that the public nature of the campaigns launched by activist short sellers has a progressive and distinct impact on business operations through their wider influence on key stakeholders. The negative impacts of CSPs on products contrast with the findings of other articles that traditional short selling can improve firm performance by disciplining managers (e.g., Chang et al., 2019; Fang et al. , 2016; He and Tian, 2016; Grullon et al., 2015; Massa et al., 2015). Our results are also consistent with the conjecture that financial markets are not an accessory to real business and that information from financial markets affects firms’ investment allocation (Goldstein et al., 2013). Previous empirical literature has examined the effect of stock market feedback on firm decisions by examining how managers learn from stock prices (eg, Chen et al., 2007; Luo, 2005). We provide empirical evidence in support of this effect by showing that learning from financial markets is also extended to non-financial corporate stakeholders, including customers and employees (Subrahmanyam and Titman, 2001).
Importantly, our results suggest that the negative impacts of ESPs on target firms are at least partly justified. The negative impact of one-stop shops on product innovation focuses on more informative campaigns and campaigns run by more reputable short sellers. Additionally, we find that the decline in product innovation is concentrated on short campaigns alleging that targets already have product problems. These results support the role of activist short sellers in uncovering information about target companies. Unfortunately, due to the public nature of short campaigns, an indirect consequence is the withdrawal of support from the target company’s key stakeholders in reaction to the negative publicity. This withdrawal creates a downward spiral in an existing product problem that might not have been so serious without the publicity surrounding the short campaign.
Countries around the world are increasingly looking at these militant shorts and considering regulating them further. Our article highlights the importance for regulators to be light-handed. Due to the feedback effect of the stock market, greater transparency of investors’ short positions can harm target companies by compounding their existing problems.
Chang, EC, Lin, TC and Ma, X. (2019). Does short selling threaten to discipline managers in M&A decisions? Journal of Accounting and Economics, 68, 101223.
Chen, Q., Goldstein, I. & Jiang, W. (2007). Informative nature of the price and sensitivity of the investment to the share price. Journal of Financial Studies, 20, 619-650.
Fang, VW, Huang, AH and Karpoff, JM (2016). Short Selling and Income Management: A Controlled Experiment. Journal of Finance, 71, 1251-1294.
Goldstein, I., Ozdenoren, E., & Yuan, K. (2013). Trading frenzies and their impact on real investment. Journal of Financial Economics, 109(2), 566-582.
Grullon, G., Michenaud, S., & Weston, JP (2015). The Real Effects of Short Selling Constraints. Review of Financial Studies, 28, 1737-1767.
He, J., & Tian, X. (2016). Do short sellers exacerbate or mitigate managerial myopia? Evidence of patenting activities. Disorganized.
Luo, Y. (2005). Do insiders learn from strangers? Evidence of mergers and acquisitions. Finance Journal, 60, 1951–1982.
Massa, M., Zhang, B. and Zhang, H. (2015). The Invisible Hand of Short Selling: Does Short Selling Discipline Earnings Management? Journal of Financial Studies, 28, 1701-1736.
Subrahmanyam, A., & Titman, S. (2001). Reaction of stock prices to cash flows. The Journal of Finance, 56(6), 2389-2413.
This post comes to us from Professors Claire Liu from the University of Sydney, Angie Low from Nanyang Technological University and Talis Putnins from the Sydney University of Technology. It is based on their recnet article, “Spiraling Downward: The Real Impacts of Public Short Campaigns on Product Innovation”, available here