The particular skill of Gotham City Research, an investment fund cum research group, is finding shares that are about to go down. In 2014 it made two big calls.
One was Spanish WiFi provider Gowex, whose founder, Jenaro García Martín, admitted fraud within days of publication of the Gotham City report; the company filed for bankruptcy.
The doyens of successful activist short sellers are Jim Chanos, who helped bring down Enron, and David Einhorn, who campaigned against Allied Capital for seven years (and survived an SEC inquiry into his own activities) before eventually making millions on the trade.
The epic battle over Herbalife continues. The company provides nutritional supplements through a network of distributors. Friends, such as Carl Icahn, call the company a multi-level marketing organisation. Enemies, notably Bill Ackman’s Pershing Square, describe it as a pyramid-selling scheme. At the moment Herbalife seems to have the upper hand; its stock is back where it was when Mr Ackman began his campaign; Pershing Square was down 20 per cent in 2015.
Reasonable people can disagree about a company’s prospects but, in a properly functioning financial market, its current and past performance ought not to be the subject of much dispute. Yet history is littered with lossmaking companies that were kept alive for years by accounting chicanery. Lucy Prebble’s musical play Enron opens with a scene in which Jeff Skilling, chief executive of Enron, toasts his company’s regulators for allowing future earnings from long-term gas contracts to be booked as profits straight away. The anticipated profits, of course, never materialised.
Law partnerships traditionally accounted conservatively for work in progress, but Quindell understood that a listed limited company could value unbilled revenues aggressively. Even Gotham City struggled to penetrate the transactions between the network of companies controlled by Mr Terry and his associates.
But managed revenue recognition and complex related company transactions are widespread practices. Companies whose basic integrity has never been in question have used such devices to generate the smooth paths of earnings growth their shareholders prefer.
When contracts extend over many years, there is no simple answer to the question of when to recognise the profits it generates. It is likewise not always easy to say whether two associated businesses are under the same control and should be consolidated, or are different entities, so that transactions should be at arm’s length. These were major issues in the banking crisis of 2008.
Regulatory difficulties do not end there. In his book on the Allied Capital affair, Mr Einhorn identifies a central problem: “The authorities really don’t know what to do about fraud when they discover it in progress.” Official action inevitably damages both the business and its share price, and no agency will be right all the time. Short selling hedge funds are not right all the time either, but when they are wrong they lose their own money. The business of trying to take down an active trading company, with consequential losses for foolish investors and innocent employees, is hard to admire: but it is equally hard to deny that Gotham City performed a necessary and useful public service.