Should investors avoid stock with a high short interest? In their March 2004 paper entitled “Short Interest and Stock Returns”, Paul Asquith, Parag A. Pathak and Jay R. Ritter examine short selling trends and test the performance of stocks with high levels of short interest. Using data covering the period 7/88-12/02 for NYSE-AMEX-NASDAQ firms and 2/76-12/02 for NYSE-AMEX firms only, they find that:
- Short interest as a percentage of total market capitalization has grown steadily over this period.
- Equally weighted portfolios of stocks with high short interest ratios reliably underperform the market; value (market capitalization) weighted portfolios do not.
- The more heavily shorted are the firms in a portfolio, the more negative is its performance.
- Heavily shorted stocks tend to be small (but not micro) capitalization growth companies. In fact, the only class of stocks that reliably produce negative abnormal returns is that of small firms with extremely high short interest ratios.
- The underperformance of high short interest firms is fairly brief, and rapid portfolio turnover is therefore necessary to capture it.
- Shorting based on valuation concerns (rather than convertible bond arbitrage) drives the underperformance of high short interest firms.
- The underperformance of high short interest NYSE-AMEX stocks is more severe and consistent than that of similar NASDAQ stocks.
In summary, investors should avoid stocks with high short interest ratios. If you already own a stock that develops sustained high short interest, sell it immediately. You can gamble on squeezes, but on average you won’t win.
