NEW YORK (TheStreet) -- The number of comments I received from How Much Longer Can Short-Sellers Stand Tesla? describing the perils of betting against Elon Musk and Tesla (TSLA) was surprising. I know for every comment on any given article there are hundreds of investors who don't comment.
Increasingly, I found a serious disconnect between the criteria many investors use to allocate capital and how the markets actually work.
There is a difference between a stock and the underlying company. The price of a stock and the value of a company are correlated, to be sure, but it's a much looser correlation than most understand.
Tesla opened for trading on Tuesday at $230 and closed at $248. Did Tesla the company rise in value $2.2 billion in under seven hours? Of course not. The underlying assets including cash, plant equipment and so forth didn't change in value.
Same can be said on Wednesday. Tesla's market cap fell over $600 million, but the company was the same at the end as it was of the beginning of the day. At the time of writing the shares are lower, but the same amount of cars and profitability is expected today as was yesterday.
To explain why a company's stock can change dramatically while the company itself isn't changing, we need to examine the mechanics of an auction based market. For any given stock at any given time, investor emotions at the individual and group level drive the price, not the underlying fundamentals of a company.
Case in point, OCZ Technology Group -- now OCZ Storage Solutions and part of Toshiba -- announced it intended to declare bankruptcy in December. I wrote about it here and here. Despite the fact the company was worth zero, the shares continued to trade for as high as an $18 million market cap. Why in the world would someone pay 27 cents a share for a company with no (or nominal) value, and no prospects?
The answer is quite easy. For the same reason investors buy Apple (AAPL), Amazon (AMZN), Tesla or any other stock. They believe the risk of loss is outweighed by the opportunity to profit. The investor may arrive at the conclusion based on the CEO, growing revenue/profit, stock chart patterns, and/or a laundry list of reasons. But a stock purchase is always made with a desire to sell (or collect dividends) for a profit.
The only way to arrive at a conclusion that shares now will be worth more at the time of sale is to believe the person selling to you is making a mistake and is selling the shares too cheaply. That's how an auction market works. You have two parties reaching a point that they disagree on valuation enough that they will trade with each other. For one, the cash is worth more than the shares, and for the other the shares are worth more than the cash.
The company itself doesn't enter into the equation because the objective is to find another party with the opposite opinion and give you more cash than you think the shares are worth.
The same is true for short-sellers in reverse. The underlying company may be highly profitable or losing money hand over fist. The short-seller looks for buyers that are willing to pay more than what they believe the shares are worth. Often a company's prospects are influential, but not always. A day trader may not even know the name of the company they are shorting, much less the one year outlook.
To express it in poker terms, a day trader isn't playing the cards, they are playing the player. They anticipate how others in the market will act, not the performance of a company.
One commenter asked, "How is shorting a company not a bet against the company in the long term?"
The answer is the bet isn't against the company, the bet is against the buyer, the counterparty who believes the shares are worth more than the cash. The short-sellers are betting the counterparty (maybe you) is overestimating what the shares will be worth at the time of buying to cover.
No one questions Tesla is a fabulous company with a exceptionally bright future. Also, no one questions its stock has value. The only debate is what Tesla shares are worth. With every single trade two parties disagree, with one right and one wrong. With a volume of 20+ million shares traded every day, it's a lot of disagreement.
Short-sellers are so convinced the shares are incorrectly valued by the buyers they have shorted about one of every four shares available for trading. That's a massive short interest, and even with Tesla's explosion higher in price, they haven't relinquished. I believe the shares continue appreciating because shorts are forced to cover while other shorts step up.
This game can go on a long time, and some may say it already has. There is no reason why $300 or more is out of the question on Tesla even if fundamentals don't support a valuation that approaches General Motors (GM) or Ford (F). Morgan Stanley (MS) recently raised its price target to $320, although the timing doesn't exactly pass my smell test.
In a nutshell, short (and buyers) aren't necessarily betting for or against the underlying company, but more often than not are betting they have done their homework better than the person they are trading with. It's a bet the other person is the "dumb money."
For almost a year the shorts have been the dumb money overall.
At the time of publication the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.