General Electric stock took a nosedive August 15 after being accused of fraud, The Washington Post reported. A whistleblower who helped uncover Bernie Madoff’s crimes claimed GE’s books are off by $38 billion. The practice of short selling could save investors a fortune.
According to The Washington Post, Harry Markopolos, the whistleblower who produced a 170-page report on GE on August 15, called the company’s bookings “a bigger fraud than Enron.” Enron, the Texas-based energy company, was made infamous in 2001 when it filed for bankruptcy after an investigation found years of malfeasance in its accounting department. However, there are ways to profit during times of Wall Street crises—and even predict them beforehand.
Jesse Livermore and James Chanos both made their fortunes in the stock market by selling short. “When you sell a stock in which you have no current position—you don’t actually own it—that is called selling short,” said Dr. John M. Longo, Professor of Professional Practice in the Finance & Economics Department at the Business School of Rutgers University. “You are literally selling first, with borrowed shares, and hoping to buy them back later, at a lower price.”
How is this done? According to Dr. Longo, a brokerage firm borrows shares from other clients, which he says often happens without the original client knowing. This is legal, he said, because when clients open brokerage accounts, there’s usually a “Hypothecation Agreement” in the fine print that authorizes such a practice.
Selling short is usually done on borrowed funds, also known as “on margin.” The downside of this is that it can cause major problems to the economy. “Sometimes, trading on margin is so extensive that the borrowings, and leverage throughout the economy, become a destabilizing factor,” Dr. Longo said. “The most famous example of this occurred with the Crash of 1929 when many investors borrowed $10 for each dollar they held in capital.”
So why is it allowed to continue? According to Dr. Longo, “Margin trading and selling short can also wring out excesses in the economy, as, for example, when a stock is overvalued, and you rightly expect to profit from it by selling it short—pocketing today’s price on the expectation that the price will fall.”
James Chanos and Enron
Short seller James Chanos bet against Enron and won big in 2001. Before that, though, he had to decide his strategy for how he’d short certain companies. “Chanos does not rely on momentum trading, but rather looks deeply into the fundamentals of a company, its financials, and its business model,” Dr. Longo said. “He looks to short three types of firms: the first is companies with a fad product; the second is companies with too much debt; and the third is companies with accounting problems.”
For an example of fad products, Chanos made money on shorting the companies who made Cabbage Patch Dolls and the George Foreman Grill. Companies in deep debt are self-explanatory. Finally, there are companies like Enron with accounting troubles. Once the darling of the energy industry, Enron had high stocks and plenty of favorable publicity. This caught Chanos’s eye.
“When Chanos analyzed Enron’s financials, he found that 80% of its reported profits were from energy trading,” Dr. Longo said. “But he also found they were earning only 7% on their trades, while their cost of capital was 10%. In essence, the firm was a house of cards being held up by some strange accounting.” Chanos also discovered that Enron was disguising its debt using “hidden off-balance sheet entities,” in Dr. Longo’s words. When this was finally found out, Enron was one of history’s largest bankruptcies, and James Chanos was dubbed “The Guy Who Called Enron.”
Selling short is a risky practice, but it can often yield lucrative results. Anybody who shorted GE last week will attest to that.
Dr. John M. Longo contributed to this article. Dr. Longo is a Professor of Professional Practice in the Finance & Economics Department at the Business School of Rutgers University. He earned an M.B.A. in Finance and a Ph.D. in Finance from Rutgers, where he also received his B.A. degree.