- 1High short interest strongly predicts low future returns
- 2Short sellers target companies with low ratios of cash flow to earnings (a red flag for accounting manipulation)
- 3They are not "momentum traders"—they are contrarian fundamental analysts
- 4Short sellers accurately distinguish between sustainable and temporary growth
- 5Monitoring short interest is essential for risk management
#The Paper at a Glance
Title: Short-sellers, fundamental analysis, and stock returns
Authors: Patricia M. Dechow, Amy P. Hutton, Lisa A. Meulbroek, and Richard G. Sloan
Published: Journal of Financial Economics, 2001
DOI: 10.1016/S0304-405X(01)00056-3
In the popular imagination, short sellers are raiders who attack innocent companies. In academic finance, they are recognized as highly sophisticated arbitrageurs who correct prices.
Dechow et al. investigated how short sellers know when to bet against a stock. They found that shorts aren't just gambling—they are performing deep fundamental analysis, specifically looking for "low quality earnings."
#The Red Flags Short Sellers Spot
The study found a strong correlation between short interest and specific fundamental ratios:
- 1High Accruals: Companies reporting high profits on paper but low actual cash flow. This is the #1 indicator of earnings manipulation.
- 2High P/E Relative to Growth: Valuation disconnected from reality.
- 3Deteriorating Margins: Subtle declines in operational efficiency.
When short sellers see these signs, they pile in. And they are usually right.
The Magnitude of the Signal
Stocks with high short interest (top decile) underperformed stocks with low short interest by significant margins over the subsequent 12 months.
Crucially, this predictive power comes from information, not just price pressure. Short sellers are identifying overvaluation that the rest of the market has missed.
#Contrarian "Detectives"
A key finding is that short sellers often bet against price momentum. They short stocks that have recently risen but have weak fundamentals.
This contradicts the idea that shorts just "pile on" to losing stocks. Instead, they act as a check on irrational exuberance, stepping in when hype exceeds reality.
"Short-sellers position themselves in stocks with low ratios of fundamentals-to-price... consistent with short-sellers using fundamental analysis to identify overpriced securities."
#How This Applies to Our Rankings
We treat Short Interest (10% weight) as a critical "negative screen."
If a stock ranks highly on Profitability and Momentum, but 20% of its float is sold short, our model applies a significant penalty. We respect the "smart money." If sophisticated hedge funds are willing to pay expensive borrowing costs to bet against a company, we should be very careful about buying it.
This factor acts as our Fraud & Risk Detector, helping us avoid value traps and "too good to be true" stories.
See stocks with low short interest →
#Academic Source
Dechow, P. M., Hutton, A. P., Meulbroek, L. A., & Sloan, R. G. (2001). "Short-sellers, fundamental analysis, and stock returns." Journal of Financial Economics, 61(1), 77-106.
Last updated: February 9, 2026