Thursday, 25 September 2008

The Purple Peril turn to shares

It has been a fine day for ludicrous utterings from the seriously ignorant. I will not waste my stubby fingers on the moronic trade union dinosaur on Question Time this evening, but the Archbishops of York and Canterbury deserve mention. Canterbury has called for short-selling to be outlawed and York called those who engaged in it "bank robbers and asset strippers". It really is mind-boggling. Not quite as mind-boggling as Gordon Brown's reference to "short-term sales", but mind-boggling nonetheless. Let's look at the basics using baked beans as an example.

Mr Bloggins wants to set up business making baked beans. He has a recipe which results in hugely tasty baked beans so he wants to make them in bulk, tin them and sell them. Mr Bloggins needs a factory and machinery but he cannot afford to buy them for cash. He could borrow the necessary money but an ordinary loan requires regular repayments of interest and he might not be able to establish steady sales for some time, so he cannot raise a loan. He decides to invite people to invest in his new business by offering them the chance to share in future profits. He needs £1million so he asks one million people to put £1 each into the pot. Because he cannot guarantee when, if ever, a profit will be made all he can offer is the chance of sharing in profits in the future. Spreading the cost of raising £1million in capital by selling shares means each investor only pays £1 so the most they can lose is £1 each. In return for their £1 investment they are given a piece of paper giving them each a 1,000,000th share in the value of the company.

The value of the company is determined by the value of its assets. The factory and machinery have a value and so does the future profit from selling baked beans. All the time only £1million has been raised from investors. If the value of the Bloggins Baked Bean Company rises to £3million because the land the factory is sited on has risen in value or sales of beans are very strong, each share goes up in value to £3. If the value of the company's assets falls, so does the value of each share because each share is necessarily worth one millionth of the value of the company's assets.

Some investors will want to hold on to their shares forever in the hope of steady profits from sales of the flatulence inducing product but others might wish to withdraw their money and invest it elsewhere. A market starts in the shares and the value of the company's assets determines the price of each share. Except that no one really knows the value of the company's assets, it can only ever be estimated. Changes to land values and changes to the likely future demand for tinned baked beans will determine how much people are prepared to pay for shares. If it is anticipated that the business might hit troubled times, perhaps through the threat of an EU tax on methane inducing products, holders of shares will want to sell them before they fall in value and buyers will only be prepared to buy if the price is right. Today the threat to the business might justify a 10% reduction in price, tomorrow some good news might justify an increase of 20%. It is often thought that shares have a value of their own but they do not, they are merely a reflection of the value of the company.

Short selling is all about anticipating a fall in the value of a company. If shares are priced at £3 today and you think they will fall to £2 because the company is in trouble you want to sell for £3 and then buy later for £2. If you already own shares it is easy, you just sell what you have, take the money and then buy once the price is £2. If you do not own shares in the company you can borrow someone else's shares, sell them and then buy back later and hand the newly bought shares to the person you borrowed from. You pay him a fee for allowing you to borrow his shares and you pocket the balance of profit. This is short selling: borrowing shares so you can sell them now and buying later so you can hand the correct number back to the lender. There are various theories about where the term "short selling" came from but the most compelling is that the person who wishes to sell does not have any shares, he is short of shares, he borrows so that he can sell even though he is short of shares himself.

Short selling is a very risky business. You sell at £3 expecting a fall to £2 but instead the value rises to £16.50. Your lender demands the return of 1,000 shares in the Bloggins Baked Bean Company and you must deliver so you have to buy at £16.50. The sale brought you £3,000 and buying replacements costs you £16,500. Ouch.

Short selling can also induce a collapse in the value of shares. All of a sudden instead of the average turnover of, say, 1,000 Bloggins Beans shares each day there are 200,000 for sale. People ask why. It looks as though a lot of people think Bloggins Beans is in trouble and the price falls through the floor. Even if Bloggins beans is highly profitable it appears that people think it will not continue to be profitable which can cause problems for Bloggins Beans itself (for example it might find credit hard to come by) and for other holders of shares in the company. People who have used shares in Bloggins Beans as security for a loan find their lender calling in the debt because there is now insufficient security. Investments based on the capital value of shares rather than dividend receipts produce lower returns and so it can go on. In other words, short selling can become a self-fulfilling prophesy.

The only valid criticism of short selling is that it can artificially deflate the value of shares and that can have knock-on effects. However, this can only happen in the short term where the company in question is strong. The other side of the coin is that short-selling can bring to light little known weaknesses in a business. Enron's shares started to fall as a result of a spate of short selling after rumours circulated about its accounting practices. Those rumours were true and the effect of short selling was entirely beneficial - a business based on deceit was brought to its knees thereby preventing future losses on an even grander scale than those resulting from Enron's collapse.

Where a sector of the economy is under pressure there is an argument for preventing the short selling of shares in that sector so that it has a chance to find its feet again (if it can) without the threat of an artificial downward force on its share prices. That is why the shares in a number of UK banks and other financial institutions are subject to a ban on short selling at the moment. Banning the practice completely will merely delay the day failing companies are exposed, and the knock-on effects of that are far worse than the limited consequences of a sound company being artificially undervalued for a limited period.

As for those who engage in short selling being "bank robbers and asset strippers", that comment merely shows the Archbishop of York to be ludicrously naive. Like so many men who spend their working lives in fancy frocks, he is best kept well away from the real world. Let him hold his shepherd's crook and pontificate about his god all he wants, then tell him him his stipend and eventual pension come from the profits the Church of England makes on the stock exchange. I wait with baited breath to hear that he will repay every penny he has received over the years from the profits of short selling.

1 comment:

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