What happens when companies engage in fraudulent activity? Short-sellers get wind of it, and, by selling the stock of the company in question, depress the share price and save uninformed investors some of the loss they would otherwise have suffered had they bought in at an undepressed level. How much is that worth? According to Xiaoxia Lou and Jonathan Karpoff, somewhere between 0.2% and 1.5% of the firm’s market cap.
But what if the short sellers have it wrong, and the company in question is not engaged in fraud? Well, in that case the uninformed investors have just been given the opportunity to buy into that question at a discount, thanks to the shorts. They win again!
Is there any downside to short-selling? Not really: the authors say that “there is no evidence that short selling exacerbates a downward price spiral when the misconduct is publicly revealed”.
So thank you, short-sellers, for saving us from buying in to fraudulent firms at inflated prices, and from giving us a nice discount on the share price of non-fraudulent firms. You rock!