Behaviour matters more to investors than structure, says Jan Rabe, Co-Head of the Sustainable Investment Office at Metzler Asset Management.
German real estate group Adler saw its share price plummet by more than 18% in a month after short sellers alleged links between the company and a disgraced Austrian property magnate that oversaw one of Germany’s largest ever real estate insolvencies.
Despite protestations over the suggestion that Austrian entrepreneur Cevdet Caner has any sway over its business, Adler’s stock went into freefall at the start of October and is yet to recover.
Viceroy Research, author of the report on Adler, said the company has been unable to clarify Caner’s role in the business adding that “until such an explanation has been provided, we refuse to assign a target price to Adler’s shares and believe they are un-investable”.
The Adler case serves as a timely demonstration of the impact short sellers can have on a company’s value when they highlight poor corporate governance. It also happens with such frequency, that asset managers are using these campaigns to inform stock picking.
Jan Rabe, Co-Head of the Sustainable Investment Office at German firm Metzler Asset Management, has authored a research paper that makes clear the impact short selling campaigns have on company share prices when the challenges relate to governance.
Rabe says: “We tried to find out what it is that all these targets have in common. When you think about ESG ratings and the accusations that short sellers make, the vast majority are around governance issues.”
The research makes an important distinction between poor corporate governance structures such as board structure and shareholder rights, and the actual behaviours exhibited within those structures, including fraud and tax evasion.
Rabe says that investors trust companies with suitable corporate governance structures and will naturally avoid those without the necessary checks and balances in place. It stands to reason then that investors will punish harshly companies that appear to subvert right and proper process.
Rabe says: “Governance behaviours such as engaging in anti-competitive practices and corruption are the common weakness in all these targets [from short sellers]. It is not structures that matter so much as how the companies behave.”
The research shows that share prices were most heavily impacted when investors pointed out non-transparent accounting (30%) and serious fraud (13%) in addition to poor reporting practices.
Short seller campaigns are more effective, Rabe says, when aimed at smaller companies. The research shows that the gross excess returns of all target companies dropped by about 10% one month after the publication of a negative report. However, small companies’ (those with market capitalisation of <EUR 5 billion), share prices did not recover within two years of a short campaign, while their larger counterparts staged a comeback.
However, it is worth mentioning that large companies are far from immune from the short selling campaigns. Only those with the shortest memories could forget the Wirecard collapse was a direct result of Viceroy Research’s investigation into widespread fraud at the German payment service provider.
Cyclical companies were also found to be more vulnerable to short seller activism. While targets from defensive sectors recovered after just one month, the downturn in cyclical stocks continued for up to 18 months after publication of the respective reports. The most frequently affected sectors were technology (27% of cases), consumer discretionary (17%) and financials (12%).
Rabe explains: “In 75% of cases, companies in cyclical sectors were targeted. Businesses that are cyclical are usually under more pressure to deliver against consensus expectations in terms of revenue or earnings per share growth because they are pressured by cycle. This makes them more vulnerable.”
The upshot of all this research is the ability to screen out companies that look vulnerable to short selling, allowing portfolio managers to shrink an investible universe considerably.
Rabe says a portfolio manager looking at the MSCI All Country Europe index which comprises 1,611 stocks could reduce that investible universe to just 71 stocks by focusing on MSCI governance scores. This falls to just 35 stocks when using MSCI scores to assess a company’s accounting profile.
Avoiding these companies does appear to pay dividends. According to Rabe, gross excess returns on shares in the target companies declined by 15% compared to the European equity market until they found their floor 18 months after the reports were published. By then, the market capitalisation of the target companies had halved. At its peak, aggregate market capitalisation of these companies lagged by up to EUR 135 billion.
“The figures are pretty impressive,” Rabe says.
Stretching to the E and the S
There is hope that the Metzler theory could be extended to environmental and social factors, allowing investors to screen out companies that look less than robust on issues such as carbon emissions or labour standards.
The PRI says: “Some hedge funds already take short positions in companies having identified significant governance issues, such as accounting irregularities. As ESG incorporation becomes more widespread within the hedge fund industry, technological, regulatory, and physical climate-related risks may also drive short activity. Some observers also point to the role that shorting might play in highlighting companies or issuers that misrepresent their ESG credentials.”
Indeed, earlier this year Oatly, the Swedish vegan milk substitute company that enjoyed a successful US initial public offering in May, suffered after a short selling campaign that claimed it was exaggerating its environmental credentials.
In July, Oatly’s share price dropped 9% immediately following a report from Spruce Capital alleging among other things that “Oatly’s production process generates dangerous volumes of wastewater that requires it to build its own treatment facilities”.
However, Oatly’s share price recovered, which Rabe says is indicative of the inability to pin companies down on E and S factors.
Rabe says: “When a short seller says a company has made a false claim on the E or S, the impact is marginal. This is because people think of it as a communication issue, and unlike with governance, there are laws and if these are broken companies face a huge fine. The E and S do not have similar legal frameworks.”
Whether the recent global push to force companies into formalising emissions reporting makes it easier for short sellers to identify poor climate change behaviour remains to be seen, but it is certainly an area ESG investors might want to monitor.
For now, Metzler’s research brings an additional and valuable device for asset managers building a better risk adjusted portfolio. And, perhaps more importantly, it might send a message to business’ top brass about the importance of ensuring they practice what they preach on good corporate governance.