Editors' Note: This article covers a stock trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
When a stock is obviously overpriced, it attracts short sellers, and this often drives up the "rebate" that shorts must pay to hold a short position. Some investors believe that a high rebate can, paradoxically, make an overpriced stock attractive as a long investment. The idea makes sense at first but doesn't hold up on close inspection. In this article I'll explain why you should rarely hold an overpriced stock for the rebate.
Let's take Great Northern Iron (GNI) as an example. On January 3, 2014, GNI had a price of $67 despite clear and publicly available information indicating that it would pay out only $21 or so in distributions over the 15 months before it expires, worthless, in April 2015.
So why was anyone long GNI at $67? Several commentators pointed to the annualized rebate, which was about 50%, and suggested that this added substantially to the income that a shareholder could expect from owning GNI. At a rebate of 50% and a price of $67, the argument went, a shareholder might expect $42 in short rebate interest over the last 15 months of the stock's life ($42=$67x50%x15/12). This $42, added to the $21 in distributions, would justify a price of $63 or so-not too much lower than the market price of $67.
This scenario was comforting to longs, but it was a fantasy. No shareholder was going to collect anything close to $42 in rebate income. First of all, only 3% of GNI's shares were sold short, so if you were a shareholder, there was only a 3% chance that your shares had been lent to a short seller. If you were in the other 97% of shareholders, no short seller was paying a rebate on your shares.
Second, even if a short seller was paying a rebate on your shares, that rebate wasn't necessarily being paid to you. Many brokers collect the short rebate and share none of it with the customer whose holdings have been lent out. Interactive Brokers is more generous to their high-worth customers; if your account has more than $100,000 in equity, IB will split the short rebate with you, 50/50. In the case of Great Northern Iron, that split means that shareholders would see just 25% out of the 50% rebate that shorts were paying to borrow shares. (Large institutions might negotiate a better deal, but hardly any institutions held shares of GNI; GNI was too small to attract their interest.)
And how likely is it that a high-worth customer's shares would be lent out in the first place? Think about the broker's incentives. If you were IB, wouldn't you lend out the shares of a low-worth customer, who you don't have to pay anything, before those of a high-worth customer with whom you'd have to split the rebate?
Finally, the argument for holding shares of GNI depends on the idea that the share price would stay at $67, and the rebate would stay at 50%, until the expiration date in April 2015. Clearly that wasn't going to happen. At some point the share price was going to move down toward its fair value of $21, and then its terminal value of $0. And when the share price approached its fair value, the rebate would decline as well, as demand to short the stock abated.
In fact, the crash happened pretty quickly. In the 7 trading days after January 3, the stock fell to $22, and now that it's there, I suspect the rebate will soon fall as well. But even if the price and rebate had declined more gradually, longs counting on short rebate income would have been miserably disappointed.
For a while the high rebate may have helped to prop up GNI's share price; high rebates do discourage short sellers and slow price discovery. But reality catches up with overpriced stocks eventually, and shareholders are left holding the bag.