Muddying the Waters

Here in our dismal pit, we perked up a bit as we read the following headline in the Grauniad:

Clarity on Burford Capital is needed after Muddy Waters treatment

A bit of background on this. The hedge fund Muddy Waters, which has no connection to McKinley Morganfield, aka Muddy Waters, the blues singer-songwriter—but perhaps it should have—issued a nice little report putting the knife into listed company Burford Capital which caused a huge drop in the latter’s share price.

Muddy Waters is a splendid name for a short-selling hedge fund that claims to spot accounting shenanigans at listed companies. Carson Block, its founder, doesn’t get it right every time, but he has a big following. That partly explains the thumping 46% fall in Burford Capital’s share price after one of the hottest stocks on London’s alternative investment market received the Muddy treatment. Over 24 pages, the hedgie alleged “aggressive” accounting practices.

Not bad, eh? A little bit of analysis on the company’s financials, disclose the report to the market, which seems to take a shine to what you do, and wham, the price drops like a stone. You’re short Burford shares and everyone panics and dumps the stock and it tumbles 46%. A nice little earner, really. Just try annualising that return.

What is interesting about the story—apart from the killing Muddy Waters made from its short position, assuming it repurchased the shorted shares pretty quickly after the stock’s dive—is the role of information in moving the share price.

Tim has commented on the role of markets as processors of information. Here we see Muddy Waters creating new information in the form of that report and changing the value that shareholders see in Burford Capital’s shares. The prior value, that is, before the report’s new information, is no longer what investors consider the shares to be worth, given the new information. Hence, the share price drops to what investors are willing to pay to receive the future benefits of holding the shares. Or even a little bit more as investors panic a bit as they ditch the shares and the price drops below fundamentals.

Note we see information driving prices all the time in the stock markets, but generally the changes are quite small. It needs a huge revision of expectations for the shares to see them nearly halve. But that is something Muddy Waters specialises in.

As Tim has commented frequently in his posts, markets tell us what to do. Information is the lifeblood of markets. The price is the message, the market the messenger.

There are a couple of other sides to this story that make it interesting. After reviewing the report in detail and hearing what Burford had to say about it, the shares recovered somewhat. What if Muddy Waters “exaggerated” the gloom in its report? Well, once the stock tanked, they’d repurchase the shares they’d shorted. But they might have gone one step further by now buying the undervalued shares and contributing to the bounce from the lows. More profit. Sneaky, eh?

The other part of the story that has lessons is that it was only by Muddy Waters sharing their opinion on the value of Burford Capital’s shares with the market (i.e. those owning and trading in the shares) that led to the price drop. Having the new information wasn’t enough. Muddy Waters had to persuade the market of their valuation. It is through trading—in this case a flood of sales of Burford’s shares—that the price fell. Action following the evaluation of the information.

This information-leading-to-action process is why the stock market is rife with rumours, innuendos, and awash with reports about listed companies. Everyone is trying to get the price to adjust in some way and are putting their money where their mouth is.

While the stock market is pretty transparent about what is going on here and in general, we see the same thing happening in product markets. Information drives prices. Oil prices go up when we hear of issues in the Gulf—and so on.

We need markets for effective allocation of resources (i.e. to adjust to new information). The pricing mechanism is what facilitates that. We need to persuade policy makers and the public of that important fact. Not succumb to dirigiste fantasies that make us all poorer.

 

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On a completely different topic, if you like fantasy as a genre, you might like to have look at my comic fantasy novel The Sorcerer’s Lackey, which is available as a digital download on Amazon. You can find it here.

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Matt Ryan
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Matt Ryan

I see a lot of comment saying short selling should be banned. The rationale is usually these people are bandits who prey off good honest companies for profit. This might be true, but having more information is not usually considered a bad thing. If you were a shareholder and don’t like their report and believe it to be factually incorrect, then you’d double down during the dip and also make out like a bandit. If however you bought because your mate said it was a sure thing and the perceived bad news makes you think otherwise and you sell on… Read more »

Phoenix44
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Phoenix44

If short selling always made people money, then everyone would do it. It doesn’t. People only complain when shorts make money, but they also lose money often enough.

Matt Ryan
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Matt Ryan

Exactly, I made money when there was a short squeeze on Porsche/VW around 10 years ago. The fact there is a term for it means it happens and costs the shorters money.

Phoenix44
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Phoenix44

When you purchase a stock you have shorted after it falls, you don’t keep the stock. You pass it to whomever you borrowed the original stock from that you sold. Shorting requires somebody to lend you their stock to sell, often someone who cannot sell the stock themselves, like an index tracker.