This Article was originally published in The Global Analyst

Indian capital market, probably for the first time, is getting a taste of the global short-selling bite through the Hindenburg Adani short-selling saga that wiped out more than $125 billion in market capitalization. Adani group listed stocks tumbled across the board after a scathing research report published by Hindenburg, a New York based short seller on January 24th, 2023. Post this publication, the market capitalization of Adani group stocks plummeted from nearly Rs.19 Lakh crores to Rs.8.7 lakh crores all in just 15 trading sessions. 

While a lot has been said about this drama that is still playing out, my focus is to look at this from four key points of view viz., Adani Group (The Target), Hindenburg (The short-seller), SEBI (The Regulator) and Investors (both retail and institutional).

Before we get into that, it will be instructive to explain short-selling as an instrument employed by famed short-sellers to call foul on companies that they deem flush with bad news. Most of the celebrated short-sellers come from the U.S. financial system that provides several legal and regulatory protection, which makes it difficult to pursue damages. Though long-term stock market investing is all about making money, in the short-term there are as many companies falling as rising. Investors are trained effortlessly to profit from increasing share prices (buy low and sell high) while sophisticated investors like short-sellers reverse this process (sell high and buy low) and make good money. But there is a small catch. In a long-bet, where one buys low with the hope of selling high, the maximum loss is a known function as technically the stock price can only go down to zero. However, in a short-bet, where one sell high and buy low, the maximum possible loss is unlimited as share prices can go up endlessly. Hence, short-sellers should be doubly careful while playing the short game. This also explains why regulators have stringent requirements while dealing with short selling. Short-selling also involves selling first and buying later which implies that the short-seller should be in a positon to borrow stocks. This is contingent on free-float.

The table below provides a glimpse of celebrated short-sellers and the stocks on which they made money by shorting the target companies.

There are several ways to short-sell like direct stocks, derivatives, options, futures, offshore, onshore, etc. Short-selling also needs good free-float for direct trading in the absence of which derivatives is resorted to. Local regulations for derivatives is quite stringent and hence short-sellers prefer the offshore route.

It is interesting to note that many of these short-sellers are based out of U.S. while their target companies are mainly emerging markets (especially China) as it is easy to spot companies with poor governance though many of them do not offer the comfort of adequate free-float (as promoters tend to hold a large chunk). In some cases, short-sellers also spot companies with outdated business models threatened by technology disruptions ripe in sectors like auto, media, retail, etc. 

Let us now turn our attention to the Hindenburg-Adani row from the angle of the four key stakeholders:

1.     Adani Group (The Target): Adani group experienced a meritorious rise in its fortunes to the point where they became the second largest conglomerate in India after Tata’s. It comprises 10 stocks primarily focused on infrastructure. The rise of Adani group coincided with India’s capex spending on infrastructure and valuation for many of Adani group stocks sky rocketed in a very short time. Infrastructure is as much a debt game as equity and hence Adani group benefitted a lot by this meritorious rise in its share price as it now can raise more debt than before (due to debt equity ratio advantage). Adani group’s debt rose 2x in 2 years with 30% of them designated in foreign currency. Also, domestic banks financed 18% of that debt. The group exactly did that which Hindeburg highlighted as a key risk though one can find many global companies with such a debt-equity structure as well. The rapid fall in Adani group stock price (see the table) made it to go down from the second biggest to fourth biggest in terms of market cap. Also, it had several other consequences for the group including cancelling a planned FPO issue and planned takeovers. The group was also forced to reduce the leverage (through early repayment) and firefight the negative press that ensued after the stock price meltdown.

2.     Hindenburg (The Short-seller): Hindenburg is a relatively less known short-seller in U.S. compared to other celebrated names. Short-sellers attack rarely but when they attack, it is with brute force. Many of them prefer to be anonymous as the idea is not to get fame but to make money. In this case, Hindenburg published a report that highlighted several issues including poor governance, stock manipulation, accounting fraud, shell companies, leverage, and audit firms that are too small for the second biggest conglomerate. While only time will tell about the credibility of these accusations, Hindenburg did achieve its objective as the target stocks fell between 30% to 80% and that is a juicy outcome for any short-seller. As explained earlier, there are several ways to short-sell and Hindenburg targeted international bonds and derivatives through off shore route as this will not constrain its strategy by locking horns with local regulations and poor free float.

3.     SEBI (The Regulator): The regulator angle to this saga is very interesting. There were questions on how stable is our Indian capital markets when a relatively unknown U.S.-based short seller can inflict a $125 billion loss in market valuation within 15 days. The key concern for the regulator is the local banks exposure to Adani group debt. In my opinion, the rigor of local capital market regulations can be measured by the market impact of the Adani saga. While the stock price of Adani group stocks fell precipitously, the broader market (read Sensex) in fact rose by 0.5% in the 15 trading sessions implying that the market participants (including foreign investors) showed broader confidence in the Indian macroeconomic story. In cases like this, where media loves to conduct quick trial, regulators normally tread a cautious path. It is not their job to pander to media frenzy and on the contrary in most of the times, they silently go to work studying the issue threadbare and come up with long-term policy solutions. If we take global examples, in the last 12 years, 3 research firms published negative reports on 18 companies. In all these cases, it took anywhere between 1 to 2 years for regulators to conclude the investigation and only in 15% of the cases, they imposed fines. Hence, regulators never show knee-jerk reactions and this is what SEBI did as well. In fact, to their credit, SEBI has already introduced a mechanism called Additional Surveillance Measures (ASM) some time back in order to capture trading interests in stocks with high volatility. I feel, apart from the strong India macro story, the robustness of the regulator can also be a key reason why the Adani short-selling saga did not transmit to the broader market.

4.     Investors: The last angle is the investor angle. Many of the retail and institutional investors that enjoyed the rapid rise in the stock price of Adani group stocks suffered a great deal after the stock price collapse. However, investors that have entered these stocks say 3 or 5 years before, are still laughing their way to the bank while investors that entered during the last one year suffered huge losses. Foreign investors suffered more losses as MSCI reduced its weight for Adani group stocks post the meltdown while retail investors that had direct exposure suffered. Many investors focused on short-term trading also must have experienced “catching the falling knife “syndrome in this episode. From an investor point of view it is very difficult to say what lessons can be learnt of this as one cannot predict the next target company in this game.

If you keep aside profit motive angle and profits earned by Hindenburg for time being, there are several positives from this saga that emerge. They include a greater focus on governance and capital structure. The episode is bound to force business groups to turn their focus on improving investor engagement, transparency in operations, and proactive communication to ward off short sellers.

While targeting Nifty 50 stocks can produce magnifying impact (like the current case), it does not solve the broader problem of poor governance among mid cap and small cap stocks. These may be out of bounds for celebrated short-sellers as these companies may not have international bonds or may be low on free-float. It will be good if regulations evolve towards this aspect of our capital market.