The spectacular demise of Let's Gowex SA is evidence that the world needs more short sellers – especially now, as stock markets reach new heights.
The failure of the award-winning Spanish WiFi provider followed the publication last week of a report by Gotham City Research, which alleged that more than 90 per cent of its revenues were pure fiction. Over the weekend, the company declared bankruptcy and said its founder had been falsifying accounts for at least four years.
Gowex's epic face plant adds to the shame for Spain's stock market, following the failure last year of Pescanova SA, a packaged-seafood giant that filed for creditor protection after an audit discovered it was secretly running up enormous debts. But Europeans aren't the only ones to dabble in creative accounting, as the collapse of Sino-Forest Corp. demonstrates.
The Toronto-based company, which claimed to be one of the leading tree growers in China, slid into bankruptcy in 2012 after a report by short seller Muddy Waters Research alleged it was a fraud. Like Gowex and Pescanova, Sino-Forest had won plaudits from investment analysts not long before its downfall began.
How could the investment community get things so wrong? It's easy to say in retrospect that analysts missed obvious clues. But the real problem is one of motivation.
By and large, Wall Street and Bay Street have no desire to dig for dirt. After all, bad news generates no investment banking revenue.
That leaves the job of breaking ugly facts to short sellers – generally individuals or hedge funds who operate outside big investment firms. They make money by borrowing a company's shares, selling them, then buying them back to return to the original lender. If the stock price has declined in the interim, the short seller pockets the difference between his sale price and his purchase price.
There's nothing illegal about this arrangement, but it does raise nasty suspicions, most of them to do with the possibility that short sellers will spread false rumours to drive down a stock price – "short and distort," as it's known in the trade.
Such things do happen, no doubt. But as Gowex and Sino-Forest demonstrate, the short sellers are sometimes simply right.
In fact, short sellers seem to have an uncannily good eye for spotting trouble ahead. In a study of 454 U.S. firms that were disciplined for misrepresenting their financial statement, short sellers were typically on the case long before the authorities. They began to vigorously short the stocks as much as 19 months before the misconduct was officially revealed.
The authors of the study, finance professors Jonathan Karpoff and Xiaoxia Lou, argue that short sellers provide a service to every investor. Strong short selling can alert authorities to potential problems; it also helps put a lid on share prices, thus limiting the damage that can occur when a business is cooking its books.
To be sure, short sellers aren't angels. They're motivated by profit and sometimes overstep the bounds of decency.
Short sellers can also be wrong, or at least early. Just ask U.S. activist investor Bill Ackman, who is still looking for payoff on his big short against Herbalife more than a year and a half after he labelled the nutritional distributor a Ponzi scheme.
But the shorts help investors by bringing to light all the negatives that the perennially bullish Street likes to play down, especially in the middle of a roaring bull market.
The downfall of Gowex shows that a short seller can win just by asking the questions that other analysts glide past. Gotham City, a shadowy firm that has previously published negative research on a handful of other firms, divided Gowex's revenue by its number of employees and concluded that the business's per-employee sales were "far above nearly all other businesses in history" and simply too good to be true.
Gowex's CEO Jenaro Garcia fired back, saying the report was "categorically false." On Sunday, he confessed and tweeted, "I apologize to all. I am heartily sorry." But not as sorry as his investors.
Ian McGugan