Betting against Apple: Why stock swarms only work when we let them

Earlier this week, Mal Spooner from Money wrote a piece about the swarming of Apple stock. In the article, he equates street swarming -- when a gang surrounds and often attacks an unsuspecting victim -- to the swarming of a stock by short sellers. The main difference, he suggests, is that in a street swarming there is no real motive. Yet in a short-seller swarming, the motive is to rob investors by driving the stock price down.

Spooner is well known on Bay Street. He founded Mavrix Fund Management at the start of this millennium, and he’s obviously quite experienced. But I still beg to differ with his view. I think it gets the investor psychology issues wrong. I also think too many people are missing an understanding of something I call the Conservation of Outstanding Shares Principle.

First, for readers who aren’t familiar with short selling, let’s cover it quickly. Most investors buy stock hoping it will go up. But it’s perfectly legal to borrow stock from your broker and sell it. Then you can buy it back later, hoping to buy it back at a lower price. If you shorted Apple at $700 and “covered” (buying back the stock) at $500, you made a profit of $200.

Shorting stock is as simple as placing an order online. We call it being “long” when you own shares the way most investors do. Shorting is the opposite. It is a bet against the company rather than a bet on the company.

Now here’s something people don’t often understand. Selling stock PERIOD is a bet against the company. People are going to argue with me here. They’ll say I’m wrong. But the fact is that selling Apple shares (for cash) means you are betting on cash instead of Apple stock. You’re betting against Apple.

Liquidity in the market depends on having a buyer and a seller. Every time you buy stock, you are betting on that company, and someone else is betting against the same company in equal dollar amounts.

I call this the Conservation of Outstanding Shares Principle. In physics, there's conservation of mass and conservation of energy. This is the same thing. Short selling does not create or destroy shares. It adds liquidity to the market.

So now let’s talk about “swarming”.

Street swarms are organized. A gang of punks is basically out to attack someone. This is very different from the imaginary scenario where a fight breaks out, and random bystanders all start attacking the same person just because it looks like fun, or just because they also want to appear relevant.

So when a stock gets “swarmed”, I think it’s a lot less organized than street swarming. Sure, you could have a few hedge funds who all collaborate with each other to start shorting a stock and planting negative stories in the media. That can be a catalyst. It’s the match that lights the fire. But the fire continues to burn on its own, doesn’t it?

The fuel in this fire is actually the media. And it is driven by herd mentality more than an organized swarming, in my opinion. If your job is to write about technology stocks or if you are a general business journalist, then the last thing you need is to seem like you’re on the outside of a trend. If you see something happening (like a developing negative story on Apple), you run over to look. You’re part of the crowd. But as a writer, you are also reporting on it - usually with no value added.

So what if 20 million shares of Apple are sold short. There are 939 million shares of Apple outstanding. An utterly enormous (sarcasm!) 2% of Apple shares have been sold by shorts. Those sellers voted against Apple, and sold the shares to buyers of that exact number of shares. Somebody else voted their dollars on Apple just the same.

On an average market day, over the last 3 months, 18 million shares of Apple trade hands every day. Every single day. There is a buyer and a seller for every single share traded. Some of the volume is from short transactions. The rest is from traditional long transactions. If you buy stock you’ve got no idea (nor do you care) whether you’re buying from someone who shorted, or someone who simply decided to sell a long position.

Short sellers are not robbing you. They do not force you to sell your shares. Short sellers do not change the value of an underlying business over the long term. They simply contribute liquidity, and often during the beginning of a short selling wave, they put negative pressure on a stock. This can go on for a while. I’m sure the fire can burn for a year or more. And for some people, that’s a long time, and they will feel like they’ve been robbed.

The truth is that long term investors who focus on actual business results can ignore all of this, or even buy more during periods of insane negativity. You can actually profit from the lows in stock prices created by short sellers.

The real problem is one that will likely get worse before it gets better. The real problem is a combination of: 1) The low barriers to publish news these days; and 2) the highly competitive need to publish quickly, which reduces quality of reporting.

The only reasonable solution is to do your own research and invest over a longer time horizon.