Ir-ratio-nality

Promoters and shareholders in REFR may vilify Motley Fool for their dogged sticking to the facts in their reporting on the company, but that doesn't mean they won't take cues from them when they think it to their advantage.

Back in the day, when the Fool ran model portfolios and dared to dip its toe in the waters of short selling and brave the backlash from the shareholders of the stock in question, they set guidelines for isolating short-sell candidates, as they do for all investment strategies.

One of the items in the Fool checklist for determining short candidates was called the short-interest ratio. The short-interest ratio is calculated by dividing the total short interest, a figure reported monthly by the exchanges, by the average daily volume. A high short interest ratio, anything above 10 or so, indicates a "crowded" short, which may be prone to a short squeeze, wherein too many short sellers attempt to cover on a downturn in the stock, thus turning it into an upturn. In some cases this can feed upon itself and turn into a huge gain for longs and a disaster for shorts. Short squeezes were everywhere one looked in the late 1990's, but have become quite rare since the peak of the bubble.

Now, I don't claim the Fool invented the metric or anything, but they certainly went a long way to popularizing it. Many investors, however, chose to use the metric the other way, deliberately looking for high-ratio stock as candidates for short squeezes. Again, this strategy worked fine from 1998 through early 2000 (then again, what long strategy didn't?), but after that, not so much.

Now, it's one thing for investors to get into the short interest ratio calculations. However, when a company explicitly start taking an interest in such a figure, warning sirens should be going off at maximum decibels. But what company would do something like that?

Guess.

Yes, the focus of that press release might have been Asensio, but there it is in all its glory, REFR commenting on its own short interest ratio. Cooler heads presumably prevailed soon after, as the logical followup press release, "Research Frontiers Issues Strong Buy Recommendation on Itself", never appeared.

A funny thing about ratios, though. Because they're a function of two other figures, there are two ways to change them. In the case of the short interest ratio, it can go up under two circumstances: a) short interest goes higher, or b) average daily volume goes lower.

I emphasized (b) above because the current short interest ratio in REFR, still a fairly lofty 27 at last report, has been skewed by a marked decrease in average daily volume in REFR over the past couple of years. (I should note that this was not the case in the press release referenced above.) In fact, short interest has declined by more than half from its peak. (There may be reasons for that which do not relate directly to normal short selling, but that is a topic for another post.)

Nevertheless, the drumbeat that REFR is ripe for some kind of short squeeze never seems to cease. 27 days to cover! Never mind that the ratio peaked near 100 at one point. One might practically expect the shorts to spontaneously combust at that level, yet that did not happen. Furthermore, the whole "days to cover" business assumes, freakishly, that if some event were to occur to prompt short-covering, that the average volume in REFR would nevertheless remain at its current level, under 25,000 shares per day. A short squeeze in slow-motion, if you will. Quite an amusing concept.

Finally, of course, they ignore the four elephants in the room, the hedge funds that bought 1,000,000 shares of REFR at a fleeting discount, who would be more than happy, at this point, to grab profits by selling to the covering shorts, and exercising and cashing out the $7.50 warrants in the event the stock got that high.

Mr. Whipple need not fret. There will be no squeezing going on here anytime soon.