Short-selling is an effective tool that can improve investors’ impact on the world and amplify the effect of increased cost of capital.
Responsible Investing: Short-Selling Increases Impact
There are three main approaches to integrating sustainability in a portfolio: namely Exclusion, Scoring and Thematic.
Exclusion is currently the predominant framework used in the industry and entails excluding companies involved in certain activities, e.g., alcohol, tobacco, predatory lending. Scoring is a more sophisticated approach which, as its name suggests, scores companies on certain attributes grouped under three main factors: Environmental, Social and Governance (E, S and G). Finally, Thematic is regarded as an evolution of the first two, using an approach that focuses on one or more areas where societal or environmental needs are spawning commercial growth opportunities.
Today, the Responsible Investor uses the three approaches above to identify and invest in those companies that are making the world a better place. However, in our view, investors can improve their impact by incorporating short-selling into their investment strategy. Short-selling is often shunned as being everything that the Responsible Investor despises but we argue below how short-selling has an active role to play in making the world a better place.
Impacting Cost of Capital
Investors have an impact on the cost of a company’s capital when they deviate from the weight of the security versus a benchmark. As an example, if certain investors underweight a company versus a benchmark, or divest from the security, other investors will need to overweight that security (versus the same benchmark) in their portfolio to allow the market to clear.¹
Since the latter are carrying a higher level of risk in terms of increased portfolio concentration, they will require a higher return as compensation. This higher return translates into a lower valuation, which in turn can be interpreted as a higher cost of capital for the security.
Short-selling amplifies the increase in the cost of capital by allowing investors to underweight a holding even more versus a benchmark, hence requiring the rest of the market to require an even higher compensation to hold the stock. In a 2020 paper, Qingbin Meng et al. found that short-selling generally worsens a firm’s financial constraints by reducing its ability to raise cheap and overvalued external capital.
Identifying Investment Trends
With regards to the environment, an example of a strategy that we at Fulcrum believe can help investors increase their impact is supporting Rail companies at the expense of Trucking companies, i.e., going long rail transportation versus truck transportation. Rail transportation is taking share from other modes of transportation. It is far more energy efficient (and hence lower emissions) than trucks due to reduced frictional energy losses (at the expense of flexibility) and hence is a credible alternative over longer distances. Meanwhile, the transition of trucks to alternative fuels remains a long way off.
Along the same lines, societal trends can also be pursued. Increasingly, health and environmentally conscious consumers are eschewing processed food, putting traditional brands under threat and facing a growing challenge from ecommerce sales; for example, new local and niche brands can establish themselves and connect with consumers more quickly, especially in the organic space. Meanwhile, valuations can become stretched on the back of perceived quality and face coming under increased pressure as interest rates rise. In our view, Responsible Investors can short-sell processed food companies versus healthier (and climate-friendlier) food companies to generate a positive impact on the world.
In our view, short-selling is an effective tool that can help improve investors’ impact on the world and amplify the effect of increased cost of capital, compared to a long-only solution that simply reweights (or excludes) securities. Moreover, it can increase a portfolio’s exposure towards those companies that are benefitting from sustainability trends vis-à-vis those that are facing headwinds, e.g., stranded assets.
 According to Wikipedia, market clearing is the process by which, in an economic market, the supply of whatever is traded is equated to the demand so that there is no excess supply or demand. The new classical economics assumes that in any given market, assuming that all buyers and sellers have access to information and that there is no “friction” impeding price changes, prices always adjust up or down to ensure market clearing.
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