This paper explores the tentativeness of short selling on identifying investment firm over-valuation, discovering that short traders adjust their transactions to utilize their internal information advantage by listing short positions prior to the release of a company’s second quarter financial statements. I show that a number of large investors use very narrow time frames to execute long positions and thus have a strong advantage over small retail investors when trading in financial markets. Financial spread betting and other high-risk strategies are used by institutional investors who have significant outside resources to purchase good or bad positions. These strategies are employed even more frequently by hedge funds, which have developed sophisticated methods to execute short selling and other high risk strategies.
I also present some counterintuitive implications of this research for monetary policy makers and other financial market participants. According to my hypothesis, large investors may use misvaluation to gain excessive shareholdings while driving up share prices to drive up the value of firms in the short run, yet eventually driving prices down once public shareholders take control of these shares. However, this over-valuation may eventually cause share prices to decline as a number of institutional investors (namely institutional investors) start to liquidate their holdings. Since, this study suggests that excess shareholdings are rarely profitable in the long run, this negative feedback cycle can occur in any financial market if institutions are permitted to buy large blocks of stock without first obtaining required approval from the relevant regulators.
Although this hypothesis is not based on current experience, it is nonetheless a fundamental premise of modern financial economics. This is not so surprising given the increasing inter-connectivity of firm communications. The internet has made it feasible for firms to communicate with one another in real time. I examine four indicators of potential misvaluations in financial markets to provide guidance in identifying and assessing potential misvaluations in publicly traded firms:
* Effectiveness of Management Inefficient capital budgeting is a major cause of inefficient financial decision making. Many firms misestimate the value of their total fixed assets while overestimating the value of their variable assets. The main reason for this difference is that most managers typically base their estimates of asset value on current assets and liabilities, rather than future cash flows. Ineffective capital budgeting is therefore a major cause of inefficient allocation of funds. It is therefore important for firms to carefully monitor their financial activity and allocate funds to both fixed and variable capital projects.
* Identification of Valued Stocks Potential investors may initially react positively to a firm’s initial growth or profit statement but may eventually sour on investment as they become disappointed in the company’s growth potential. When this occurs, stock prices of the firm fall. This is a classic example of the principle of the value of money. A firm with no growth potential will necessarily lose value; therefore, stock prices will decline over time. By carefully monitoring capital budgeting and identifying good investment projects early, a firm can avoid falling into this trap.
* Selection of Investments Inefficient management practices are not the only causes for poor investment decisions; inadequate identification of suitable projects, poor data quality, and / or delays in investment can also result in poor decisions. Some firms mistakenly select projects based on raw talent or on hiring the wrong professionals for the project(s). While it is important for managers to carefully select appropriate candidates for investment projects, they must ensure that these investments are suitable for their firm’s needs. Not doing so could result in a loss of profits and influence future decision-making. Similarly, firms that fail to adequately analyze data can make bad decisions such as choosing projects that yield low returns. Managers must therefore carefully examine data related to costs and risks before making investment decisions.
