Identifying and shorting fraudulent companies is crucial to avoid financial ruin
Thorough research, diversification, and staying informed are necessary for successful short selling
Short selling requires discipline, risk management, and understanding market dynamics
Deep dives
Valiant Pharmaceutical: A Case Study in Fraud and Short Selling
Valiant Pharmaceutical, once a prestigious American pharmaceutical company, fell from grace after its unethical business practices came to light. The company, known for acquiring drug companies and raising prices, engaged in fraudulent activities that eventually led to its downfall. Short sellers, such as John Hempton of Bronte Capital, recognized the fraudulent practices and made successful bets against the company. Valiant's major fraud revelation involved its partnership with a mail-order pharmacy called Philidore, which was used to inflate sales numbers by pushing expensive products onto insurers. The company's stock price tumbled, resulting in several people associated with Valiant being charged with fraud. The aftermath of this case highlighted the importance of identifying and shorting fraudulent companies.
The Challenges and Risks of Short Selling
Short selling, while potentially lucrative, presents various challenges and risks. Successfully exploiting an edge in short selling without risking financial ruin requires careful considerations. Position sizing becomes crucial to mitigate potential losses. Betting against fraudulent companies can yield significant returns, but if the market believes the fraud, the stock price may surge, leading to increased short positions and risk of large losses. Short sellers also face the challenge of distinguishing between short-term luck and genuine edge. It is imperative to stay informed, maintain diversification, and be aware of market dynamics that can unexpectedly impact short positions.
The Need for Thorough Research in Short Selling
Thorough research is essential when identifying fraudulent companies for short selling. John Hempton's approach involves using both pattern recognition and technology to discover frauds. He relies on a massive database of penny stock newsletters and analyzes the relationship between people involved in frauds. Hempton follows the assumption that once a scammer, always a scammer and that those associated with scammers are likely involved in fraud as well. However, he acknowledges that research has its limitations, and finding an optimal bet size or quantifying edges accurately can be challenging. The goal is to deploy technology to depersonalize decision-making and remove emotional biases from the process.
The Intersection of Gambling and Short Selling
Engaging in short selling can be seen as a form of gambling due to its inherent risks and uncertainty. The outcomes of short selling bets are influenced by human behavior, market dynamics, and the unpredictability of fraudulent schemes. Just like in gambling, managing position sizes and staying in the game are critical in short selling. Embracing an edge and navigating the temptation to chase hot stocks or join market manias require discipline and a clear understanding of one's strategies. Short selling, when approached with careful research and risk management, can provide negatively correlated returns that outperform the market.
The Market, Fraudsters, and the Importance of Regulation
The stock market attracts fraudsters due to the opportunities it offers to deceive investors. Fraudulent schemes often exploit investors' ideologies or play on market trends. Regulatory agencies play a vital role in protecting investors and maintaining market integrity, but their effectiveness varies. Weak regulators and regulatory capture can allow fraudulent activities to persist. Identifying fraud requires a combination of due diligence, pattern recognition, and understanding human behavior. Navigating through market bubbles, correlated fraudulent schemes, and the changing landscape of investors require adaptability and a focus on separating viable investments from fraudulent opportunities.
John Hempton runs Bronte Capital, which generates its excess returns primarily through shorting fraudulent companies. John walks through a hypothetical short, explaining how they find it, how they size positions, and the kinds of returns that can be expected. He also discusses his shorts of Valeant Pharmaceutical and Wirecard.
John Hempton on Twitter: https://twitter.com/John_Hempton John's Blog: http://brontecapital.blogspot.com/ Netflix documentary on Valeant: https://www.imdb.com/title/tt7909184/
Email the show: riskofruinpod@gmail.com Follow the show on Twitter: https://twitter.com/halfkelly
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