By Chicago Booth Review
On this episode of the Capitalisn’t podcast, hosts Kate Waldock and Luigi Zingales argue about short sellers and their role in the market. Luigi talks with Fahmi Quadir, known as the “financial assassin” for helping expose fraud and misconduct at Valeant, but Kate isn’t convinced—she thinks journalists and regulators are the real heroes.
Luigi: Hi, this is Luigi Zingales at the University of Chicago.
Kate: And this is Kate Waldock from Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.
Luigi: And, most importantly, what isn’t.
For a capitalist system to work properly, we need information to be produced and disseminated. While there are a lot of mechanisms to collect and distribute good information, information that is positive and rewarding, it’s much less easy for negative information to be collected and distributed. So, who makes sure that fraud is identified and exposed? One crucial role in this is played by short sellers.
Kate: So, who are these short sellers, or what is short selling, exactly? It’s kind of like the opposite of buy low, sell high. You sell high first and then you buy low. There’s a question of how you do that, right? How can you actually sell high if you haven’t bought yet?
The mechanics of shorting involve you first borrowing a security, so let’s say borrowing a share of stock from somebody else. They have to be willing to let you borrow it, and so you have to talk to your broker, your broker talks to their broker, you make sure that everyone is on board with the borrowing agreement, but you borrow and then you sell it in the market immediately.
Then, later on, if the stock price falls, you buy it back from the open market, and then you return it to the person you borrowed it from. That way, if the stock price did indeed fall, you would make money on the amount by which it fell.
Luigi: Short selling is an extremely risky business for two reasons. Number one, the upside is limited. At best, the stock goes from the current price to zero. At worst, the stock price keeps rising and your loss is infinite.
Second, even if you have the right bet, but in the middle of your position, the person who lent you the shares decides that they don’t want to lend you the shares anymore, and they ask for it back, you are forced to buy back shares in the middle of the trade, and at a time where you might be in a situation where other short sellers are trying to do the same, and that pushes the prices up, making your losses even larger. That’s called, in jargon, a short squeeze.
Kate: I think this idea of unlimited downside is sort of a fiction, though. The reason that if you take a short position you usually need to post collateral is that eventually, if people are worried about your ability to repay the security, then, as you mentioned, they’ll either demand the security back or they’ll take whatever collateral you’ve put up in order to protect themselves.
At some point, if you’re losing enough money on a short position, it will be closed out. You’re not going to lose an infinite amount of money.
Luigi: You are right, but I think the reality is asymmetric, that there is more to be lost than to be gained. And remember, on average, stock prices go up, and so, on average, you lose money. So, you must be particularly good in identifying the bad stocks in order to live as just a short seller.
Kate: And precisely because of this, there aren’t that many funds that have a pure short strategy, which is to say that they only take short positions. There are a bunch of hedge funds that have long/short strategies, so they go long stocks and they go short stocks at the same time, or depending on market conditions.
But it’s tough to take a short-only strategy, because oftentimes, if you decide to buy stocks whose prices are falling, this is called trying to catch the falling knife, and that strategy, on average, is not going to make you money. And, as Luigi mentioned, for the most part, stock prices go up, so if you’re always just betting against the market, that’s not going to make you money.
To be a good short seller, you need to be able to identify companies whose stock prices are dropping, and they will be permanently dropping, and these tend to be companies that are either in industries that are just on the verge of death, or more likely, companies that are engaged in some sort of fraud, have some sort of scandal underlying them, or are right on the verge of failure.
Luigi: In a sense, this is an aspect of short selling I like, the idea of doing good and making money. If you are a good short seller, you expose fraud and you make money at the same time. It’s like a modern version of the bounty hunters that were going after criminals and making money.
Kate: To be fair, bounty hunters still exist. In fact, they make for very popular television.
Luigi: OK. Why don’t we meet a contemporary bounty hunter, Fahmi Quadir, who at the age of only 26 exposed Valeant, one famous pharmaceutical company, as an overhyped stock and made a fortune for the fund she was working for, and after that she walked away and created her own hedge fund, which is a short-only fund.
Kate: Unfortunately, I couldn’t make it to the interview because I was teaching all day, but I will chime in a little bit later, because I’ve got some thoughts about this interview.
Luigi: First of all, thank you for being on the show. This is a great opportunity for us to talk about a crucial aspect of capitalism that is not very much loved, which is shorting. Can you explain why this is such an important aspect of financial markets?
Fahmi Quadir: I think we live in a world where markets encourage companies to engage in varying levels of obfuscation, whether it’s at the corporate level or on their financial statements. So, short sellers are
. . . At least fundamental short sellers are really hoping to break through that obfuscation and provide some clarity as to what is really going on at a company, so there is ultimately true price discovery, and the stock price is more reflective of the true intrinsic value of that company.
Luigi: Can you explain to us what exactly is this dynamic between you and the companies?
Fahmi Quadir: One thing that we like to look for as short sellers are companies that complain about short sellers. Generally, if a company is focused on its operations and doing well and delivering to shareholders, then they will welcome short sellers, because it’s an opportunity for the share price to go higher, because at some point we have to buy those shares back.
But a company that has something to hide, they typically will act very negatively to the presence of short sellers. And it’s not just short sellers themselves. Sometimes, if there are skeptical Wall Street sell-side analysts—very rare I know, but they do exist—those analysts will be barred from asking questions on conference calls. They won’t be given access to management.
All of these behaviors . . . Even a toddler will tell you, it’s their attempts to hide something, to keep secrets and not be totally forthcoming. The only reason you can really ascribe to that is the fact they may be engaged in these same exact behaviors that short sellers are alleging.
Luigi: This is a little tip for a criminal CEO, don’t lose your temper and be nice with the short sellers, because otherwise you give away who you are.
Fahmi Quadir: Yeah. But fortunately for us, it seems that these guys can’t help themselves.
Luigi: Or they don’t listen to our podcast. That’s the problem. Most usually, I think that many people, in spite of the little explanation we gave now, see short selling as a bad activity. At some point a congressman said that short selling is un–American.
It seems like you are rooting for the other team. You are not only a contrarian, which is another side of that term, but you are antagonistic and hoping that things go badly. How can you respond to all this flurry of emotions?
Fahmi Quadir: If you are a believer in the free markets, then you should be a supporter of short sellers. We certainly play a role in keeping the markets efficient, as we discussed about price discovery.
But the way that I approach short selling, and the way we do at Safkhet, is we’re going after companies that are engaged in bad corporate practice, and that involves exploiting people, including exploiting Americans. Part of what we do is getting to the truth of what they’re doing and expose them so that they can at some point hopefully meet justice, so I don’t think there’s anything more American than that.
Luigi: So, you are making money by doing good?
Fahmi Quadir: I wouldn’t be doing it otherwise.
Luigi: Talking like a true millennial. Tell us a bit about probably the trade that made you most famous. Everybody has one high moment, and at least for the time being, your high moment is shorting Valeant. Can you tell our listeners how you first identified there was something wrong and what happened then?
Fahmi Quadir: Right. Valeant was the second short I ever put on in my entire life. I was first exposed to the company when I worked in pharmaceutical corporate intelligence. It was a company that there was an unspoken rule we’d never work with them, because they were known to be unethical. They were known to not pay their consultants, so they already had a bad reputation.
But the thing is, as a short seller, one thing we look for when a company is supposedly disrupting an industry, but it’s an established industry where there are certain norms that are adhered to, not just for purposes of convenience, but also for profitability.
With Valeant, we noticed that the business model was completely anomalous to the industry. The business model was to cut out R&D and to just raise prices. This didn’t really make sense, because the pharmaceutical industry itself is relatively profitable. It has better margins than most industries, so there wasn’t really much disrupting that needed to happen.
But what resonated so well with Wall Street was that it was very similar to a private-equity firm. It was all about managing costs and improving profits, and all the while taking on inordinate amounts of debt.
But I followed the progression of this, and it was only until I saw that the ability to access capital was basically cut off after they had acquired Salix that it became an attractive entry point for a short position, because the great thing about fraud is it can be incredibly profitable up to a point, and for me it seemed like that was the right point, because they couldn’t really keep the business model going with additional leverage.
So, I shorted it, and I continued pressing and building that short position on the way down as I investigated the company further and really tried to understand the nature of the fraud and how they were taking regulations that had been in place as far as reimbursement from private insurers and from the government and using that to enrich themselves.
All the while patients were getting hurt. The calls that we would get from whistleblowers and from patients who were taking these drugs still haunt me to this day. But, yes, it was, I guess, my first big short.
Luigi: Yes. But you are quite a character, because on the other side of the short, for people who don’t know, don’t remember, there was one of the most famous investors in Wall Street, Bill Ackman, who actually not only sort of invested in Valeant, but also defended the strategy of Valeant, so you kind of had a “high noon” moment and you won, so tell us about how.
Fahmi Quadir: Well, see, I’m not from the world of finance, so I didn’t really see it as so much of a duel against Bill. It was really, for me, with Valeant or with any other trade, I need to be right on the facts. I have to be able to justify to my investors why I’m taking on these positions.
Unlike Bill, on my side of the trade I have an infinite amount of risk. The stock price of Valeant or any other name that I’m short can go up forever, whereas on the other side, if I’m wrong it can only go to zero.
Luigi: This is an important point that most people don’t get, because they always think that shorters are very aggressive. In fact, in my view shorters are very timid and fearful, and they tend to only attack animals or companies that are really sort of close to death, because that makes it easier to actually profit.
Fahmi Quadir: I take issue with the word timid. I wouldn’t say we’re timid, we’re just very calculated.
Luigi: Prudent, I would say. They are prudent. OK.
Fahmi Quadir: Yes, prudent is a good word. To be a short seller, and because we’re up against those sorts of risks, you have to be right on the facts, so it’s about doing 10 times the work that the person on the other side of the trade is doing.
We saw the presentations that Bill had made. We saw that his justification for believing Valeant was not a fraud was because he asked Mike Pearson, the former CEO of Valeant, is Valeant a fraud? And Mike said no. So, that’s not a sufficient answer for me, so I had to go out and do proper due diligence and really investigate and prove my thesis.
That was compounded by the fact that this was my second trade of my career. I had no formal finance or accounting training, so I again had to prove myself, all the while proving my investment thesis. In the end, yes, I may have won, but it was never about Bill or anyone else on the other side of the trade. It was purely about the work that I had to do.
Luigi: What made you willing to take this bet that other people were not willing to take, and how is it possible . . . Maybe I’m talking too much like a Chicago professor here, but how is it possible that this information does not reach the market, that it needs you to reach the market?
Fahmi Quadir: Well, I think it starts with the questions that are asked of these companies. I think with something like Valeant, where the narrative was just that there was a lot of financial engineering, it was basically this private-equity type business model, and the stock was just . . . every year it was compounding and compounding and making lots of fund managers very wealthy, and the best performing funds all . . . what was their top holding? It was Valeant Pharmaceuticals.
It’s tough for an investment manager to take a stand against that. It’s not as tough for someone like me, who was an outsider and who really didn’t have to deal with those types of dynamics. I didn’t have any bridges that I potentially could burn. It was really just about asking the right questions and getting to the bottom of what was going on at the company.
Luigi: Generally, the first person saying that the emperor has no clothes gets shot, so how do you avoid getting shot in this situation?
Fahmi Quadir: Running a short-only fund, we’re taking bets against companies that are much larger than we are. They could go to any length to try to intimidate us out of our position. So, how do I keep this business model sustainable?
For us, part of that is just taking nonpublic positions, so we aren’t publishing research, we aren’t exposing ourselves to potential litigation damage, and we aren’t exposing ourselves to the attacks from these companies.
But even still, even though we aren’t making those public efforts, we have companies that are coming after us directly. Safkhet only started trading in January, but we’ve already faced very significant, orchestrated, sophisticated attacks on the cyber front as far as hacking, cyber surveillance, cyber intimidation. I even have to deal with physical surveillance, and it’s all because these companies don’t want us investigating their wrongdoing.
Luigi: You mentioned journalists earlier, and in order to make money, you not only need to make the right bet, you also need this right bet to be recognized by the marketplace. Basically, there are only two ways to do it. One is to have some journalist write about it, or to have the regulators go after the company. Which strategy do you prefer, and what are the plusses and minuses of the two strategies?
Fahmi Quadir: We try to keep all of those options in our toolkit. I think it really depends on the type of information that we’re trying to get out there. With every company that we do short, we will send our work to the regulators in due time, but that’s something that will take lots of time. Regulators require resources, and sometimes they won’t even direct any resources towards that particular company that we’ve been investigating.
With journalists, again, they’re also limited in resources, and even more so, I think, not enough support is going to our journalists. We live in a world where journalists are just killed for telling the truth, so it’s difficult for them to—
Luigi: Fortunately, not in this country yet.
Fahmi Quadir: I hope never. And it’s . . . From that point of view, journalists are also taking on very significant risks, and they are not getting the financial upside that short sellers get, but they play a crucial role in letting people know what goes on at these companies. But again, they have to be limited in the types of information that they get out there.
Luigi: You just said something a little bit earlier that was very interesting. You said that when you’re a shorter, you have to be doing your homework 10 times as hard as everybody else because it’s such hard work. Sometimes I hear this same expression, the same line vis-à-vis women, that in a man’s world they are forced to be 10 times as good in order to succeed. Is there a correlation within the two facts? How does your being a woman make you a short seller?
Fahmi Quadir: Well, being a woman and being in the fields that I’ve been in . . . I’ve never been in any sort of field where there have been a lot of women. It’s always been male-dominated, even when I went to college. At the time I went to Harvey Mudd, it was 70 percent men, and that wasn’t even that long ago.
For me, it’s more of, I won’t put up with BS. That’s why I’m here today, and I think women
generally . . . They have to put up with a lot of BS, but at some point, they shouldn’t.
Luigi: You have a nickname in your trade. What is it, and why?
Fahmi Quadir: So, I was named “The Assassin,” and just the backstory there, when I had started out, I would do my research and I would send it to other folks that were looking at these companies. Those folks would then ask, “Oh, who is this guy?” “Oh, it’s just The Assassin.” Then, eventually, people realized The Assassin was me, and I’m certainly not a dude.
Luigi: And you made the news with the fact that you shorted Tesla. Can you talk about this?
Fahmi Quadir: Well, yes. I can talk about Tesla. Again, we don’t really disclose positions, but journalists like the headline “Valeant Short Seller Now Shorts Tesla.” We’ve avoided shorting the company, because typically when there is mania and hype, mania and hype can continue for a significant period of time, and that means more losses and potentially business-ending losses if you’re a short-only fund, so we’ve avoided it. That being said, there’s so much that has been exposed—
Luigi: And we are looking forward to this “high noon” moment with Elon Musk. So, thank you very much for coming, and we look forward to seeing the next killing of The Assassin.
Fahmi Quadir: Thank you.
Luigi: Kate, now that you heard her interview, what do you think?
Kate: I think that Fahmi sounds like a smart and very capable and charismatic and well-spoken young woman. I think it’s great that she has made a name for herself in a male-dominated industry. But I take issue with the idea that we should be elevating hedge-fund managers, or anyone for that matter, who pursues a career of just making markets more efficient.
I don’t think that that’s something that we should be celebrating as a society. And I think that the reason for that is that there’s already so many young people flocking into the finance industry that it’s sucking up a lot of talent, and if we start celebrating these people as heroes, that’s only going to compound the problem.
People wouldn’t flock to finance if there weren’t money to be made, and I think that part of the reason that money is being made in the financial industry is because traders and hedge-fund managers make markets more efficient, so they take information and they incorporate that into prices.
I understand that that’s an important role that someone has to play in society, but I think that another reason, and maybe most of the reason why people make money in finance, has not so much to do with market efficiency, but to do with collusion between banks and local monopolies, or monopolies in certain types of securities, and the cozy relationship between Wall Street and DC, and all of these people justify their existence by saying, “Oh, yeah, we’re making markets more efficient.”
Luigi: Wow. What do you really think? Look, if you’re talking about a high-frequency trader who is making millions by quote-unquote making the market more efficient, I could be on your side. But in this case, I think it’s different. It’s not really just making the market more efficient. It is discovering fraud, preventing bad companies from wasting our money.
After all, you celebrate journalists when they write a piece like the Theranos piece exposing that the company was fake. What is wrong with celebrating somebody that exposes Valeant doing a strategy that is detrimental to American society, to people who are sick, and that without her work would be still there, doing that stuff?
I’m with you in saying we should not just celebrate finance people because they make money, but I think that we should not fall in the opposite direction and say we should criticize them all just because they make money.
Kate: I wasn’t criticizing them on the grounds of making money. And to your point about exposing fraud and exposing corruption, that’s not what her fund does. She explicitly said in the interview that they don’t disclose their positions publicly. They take a financial position, a short position, hoping that eventually later on people figure it out and the stock price falls.
But it’s not like they’re out there sounding the alarm. They’re just waiting privately for other people to discover that, for journalists to discover it and make that information public.
And also, Valeant in 2015 was being investigated by the SEC. It’s not like regulators were completely sleeping on the issue. And pretty soon thereafter, charges were brought and that led to the downfall of Valeant.
She talks about how regulators need more resources, and I totally agree. But if you’re on the side of exposing fraud, then go be one of those people who works for the SEC. Go work for one of the regulators. Don’t just work for a hedge fund where you take a short position and then keep your lips shut.
Luigi: I think you’re missing the fact that she diffuses the information, not under her name, not to be too much of a target. In fact, she was known as The Assassin during the Valeant case because her research was circulating, and as she said in the interview, she does pass information to the regulators and to the newspapers, and I bet money that the Valeant investigation in 2015 was caused by her research being given to the regulators.
Kate: It wasn’t.
Luigi: How do you know that?
Kate: Because they were aware of the situation before that.
Luigi: Look, I read in the paper about who blows the whistle on corporate fraud, and most of the time they are not the regulators. Most of the time, they are either employees talking to newspapers or short sellers. The regulators are late to the game, and very often even when they are told, they don’t act.
Like in Madoff, they went three times to the SEC saying that Madoff was a fraud, and nobody pursued that. If there was the ability to short sell Madoff, I think the Madoff scandal would have been discovered much earlier.
Kate: I agree with you that the SEC should act faster and that it needs more resources, but I don’t agree with you that just because the SEC acts slowly, that we should just rely on the short sellers as the heroes.
I thought your bounty hunter analogy was perfect, which is that bounty hunters from the perspective of society are not heroes. These are people who aren’t formally trained. They’re vigilantes. They don’t care about justice. They just care about making money.
If you actually cared about helping out the community and going after bad guys, you would be formally trained and you would work in formal law enforcement. It’s the people who don’t want to do that that are the bounty hunters.
Luigi: Wait a second. There are two things here that really get me the wrong way. The first one is, I don’t understand this “formally trained.” You can do a great job even without being formally trained. In fact, Bill Gates was not formally trained. He dropped out of Harvard, but I think he did a pretty good job. So, I don’t think that that’s the characteristic.
And second, I go back to Adam Smith. It’s not for the goodwill of the butcher and the baker that we get the meat and the fresh bread every morning. It is for their private interest.
I don’t see what the problem is in using private interests to reach the public good. That’s exactly what capitalism is about, good capitalism.
Kate: Sure. I agree with you, and we’re both in favor of a general capitalist society. But when I was in college, I hate to say it now, but I was in charge of two investment funds, these two student-run investment funds. Young college students, to them the idea of being able to make a ton of money just by being able to pick up on people’s personalities and having a good gut feeling about the market, that idea is like crack.
It’s worse than crack. It’s like fentanyl. It sucks them into the finance industry and it convinces them that they can make a ton of money without having to work hard or without actually having to have any experience or any specific knowledge, and I just think that it’s so dangerous to be disseminating ideas like that.
Luigi: But I think you are missing the bigger point here. I’m not saying that everybody should do what Fahmi does, and I don’t think in general that not having training is good. However, I recognize that training also brings distortions and brings some buy-in to a system that does not allow you to see the system from the outside.
I think that it is not a surprise that the biggest innovators tend to be outsiders who don’t fit into the system and see the system with a different pair of eyes. Do you want everybody to do that? Absolutely not. But do we need in society some people who do that? I think so, and Fahmi is one of those.
Kate: Sure. As I said initially, people need to make markets efficient, and if that means on the short side you need people with different perspectives, fine. I think that’s fine. I have no problem with the existence of short sellers, but I don’t think they’re any different than people who run long-only hedge funds, and they’re discovering positive information in order to make money. It’s all the same to me.
Luigi: Actually, I disagree here, because people who run long-only funds, they don’t get arrested, they don’t get hacked, they don’t get followed, they don’t get to be told they’re un–American and they are hated by people. I think it’s very hard to be a short seller, exactly like it’s very hard to bring bad news, and we need people who bring bad news.
The reason why there are stock market bubbles is there are not enough people who are willing to tell the bad news. I like to celebrate people who have the guts to do that, especially when they’re young, because you’re right that she only had one really big, successful short. But now we have a second test. Apparently she’s shorting Elon Musk and Tesla. Do you think she’s going to win on this one?
Kate: I mean, look, I’ll be the first person to make fun of Elon Musk. I actually dressed up as Elon Muskrat for Halloween. So, I have no problem with the position that she’s taking.
Luigi: What did your costume look like?
Kate: First, I wore a Tesla shirt, and then I got muskrat ears, or the closest I could find to it, and taped a rubber snake on top of it in the hopes that it would look like an eel, so, get it, eel on muskrat. And I had whiskers and claws and a tail, a rat tail and stuff. But then I also was carrying around a cigarillo that was meant to look like the blunt that he was smoking on that radio show.
Luigi: I think that people will flock to our Facebook page to see your picture impersonating Elon Musk.
Kate: I wish I hadn’t mentioned that.