Originally published by Cuffelinks
Short selling (shorting) has become increasingly prevalent in our stock market, with its potential impact best seen in the fate of targets such as Slater & Gordon (AX:SGH) and Dick Smith. Even those investors unlikely to consider shorting themselves ignore it at their own peril.
Short selling is aimed at profiting from a decline in the share price. It involves borrowing and selling shares first and then buying them back sometime later, hopefully (for the short seller) at a lower price.
A risky game
Short selling is a risky game, and best left in the ‘don’t try this at home’ basket. Indeed, we at BAEP doubt we would be good at it, given our focus on good-quality stocks to invest in rather than inferior ones to short.
On any trade, short sellers are up against the odds. They must pay the ongoing costs of borrowing stock for the duration of the trade, which includes interest costs and payment in lieu of any dividends (sometimes including the value of any franking credits). Depending on the target company, these costs can add up to 8% annually or even more, which represents the amount by which the shorted stock must drop to break even.
Short sellers are then up against the clock, having to deal with the tendency for stocks to rise higher over time. The most they can return from a short position is 100%, assuming the share price falls to zero, while their potential losses are unlimited, because in theory the increase in a share price has no upper limit.
In addition, the short seller’s hand can be forced. As in the case of margin lending, if the share price rises then the short seller will need to post additional collateral, or buy back the stock. Sometimes this can lead to what is known as a ‘short squeeze’, where the buying pushes the shares higher, causing additional losses and requiring even more buying.
Unlike a long position, an unsuccessful short position gets larger in one’s portfolio as the share price rises, and disciplined risk management becomes necessary. For example, many hedge funds will set stop losses around a price rise of 15%. This adds more complexity to the portfolio, and, in the end, more distraction.
Contrary to the popular view, short sellers don’t usually benefit from the price decline that can sometimes result from the short selling itself – even if the selling is aggressive. Ultimately, short sellers must buy back the shares they shorted.
Only shareholders have shares to sell, and these same shareholders hold onto their shares at the higher prices at which the short seller originally went short. Unless these shareholders have changed their view of the company, they are unlikely to want to sell them at a lower price at which the short seller can book a profit. Therefore, to profit from a short requires a deterioration in the market’s view of the stock’s value, which in turn requires a change in investor perception, or new adverse information that comes to bear.
Why go short?
At its crudest, investors go short because they believe the share price is going down, a trade that amounts to an outright bet against the company. Short sellers typically look for looming problems in a company that have been ignored or dismissed by the market. The red flags that short sellers look for and of which all investors should therefore be wary are:
- negative or poor cash flows
- unconventional or aggressive accounting, where real earnings fall far short of reported numbers
- frequent or outsized acquisitions
- indefensible business models
- a reliance on regulatory funding or licensing
- overly promotional management
- poor corporate governance
- insider selling by executive and directors
- a need for capital, requiring ongoing support from equity and other investors, and
- excessive debt.
Shorting commonly forms part of a broader portfolio approach in which shorts sit alongside long positions. The aim of the shorts is to provide some downside protection by making money when the market falls, and thereby offsetting losses incurred elsewhere in the portfolio.
Here, shorts are often as much about the benefits of hedging than an outright bet that particular shares will fall. Indeed, the shorting decision is often a relative one, specifically aimed at finding stocks that will underperform the market rather than necessarily fail.
For example, a ‘pairs trade’ of buying Ramsay Health Care (AX:RHC) and shorting Healthscope (AX:HSO), another private hospital operator, is likely to be based on a view that Ramsay’s shares will perform better than Healthscope regardless of whether both shares go up or down. The position may achieve positive returns in both bull and bear markets. Like all investors, short sellers will have varying degrees of conviction in their positions, from what they think is a ‘zero’ – their share price target – to merely below average.
A good indication of short seller conviction can be seen from the percentage of a company’s shares shorted (available on ASIC’s website). Investors should pay attention to high or fast-rising levels of short interest in stocks.
Aggressive tactics
Investors should be aware that short sellers might target a corporation already in their portfolio or under consideration.
In recent years, we have observed short sellers being increasingly more determined, coordinated, aggressive and effective in their efforts. This mostly involves publicising negative views – for example, reverse-broking to sell-side analysts, distributing their own research reports, and feeding the media. Indeed, the media appears willing nowadays to sensationalise the short sellers’ negatively-biased stories.
Understandably, this can cause anxiety among targeted companies and their shareholders. Investors, and sometimes even the regulator, may demand answers to the questions raised by short sellers. Companies are forced to defend themselves, which means a step-up in disclosure on potentially difficult issues.
What is the track record of short selling?
Recent high profile scalps include Slater & Gordon, Estia Health (AX:EHE), and Quintis (AX:QIN).
Short sellers haven’t, however, always been right. They have been consistently wrong in shorting the banks. Against their expectations, the housing market hasn’t crashed, nor have bad debts risen meaningfully. This so-called ‘widow-maker’ trade has been costly.
Our own analysis has found wavering correlations between the short interest of a stock and subsequent returns. Stocks can go up and down a lot, regardless of whether they are heavily shorted or not. Indeed, ASIC’s historical data shows that some of the most heavily shorted stocks of one or two years ago have actually turned out to be very strong outperformers. Short sellers operate with the same uncertainty as all investors. If their calls don’t work out, they are a forced buyer of the stock as they’ll eventually need to close out their short position.
Therein lies the opportunity. Heavily shorted stocks in which investors have conviction may work out better and quicker than would otherwise be the case. Shorting may cast a shadow over a stock and depress the share price. This can potentially provide an opportunity to make outsized returns that benefit from the shadow passing.
Flight Centre: a case in point
A good example is Flight Centre (AX:FLT), which since 2012 has consistently been one of the most heavily-shorted stocks on the ASX. The short interest has been premised on a view that its predominantly ‘bricks and mortar’ travel agency business is structurally under threat from online competition.
In reality, the company is much more diversified and its customer offering better positioned than the shorts give it credit for. Notwithstanding that genuine online competition has been around for more than a decade, Flight Centre has managed to grow its market share of travel bookings, which now tops $20 billion.
This year the company has refocused on costs, culminating in the announcement of a five-year transformation programme. This transformation should see continued growth in travel bookings leverage into strong earnings growth, especially if its aggressive financial targets are achieved.
The shorts’ negative view pushed the share price down to around $28, from which the shares have risen to around $48.
The lesson for investors is to be aware of, but not to fear, short selling. Investors should always be conscious of what short sellers are up to. At BAEP, we seek to understand their views, test them against ours, and investigate the possibility that they might be right and we might be wrong. Ultimately, research is an investor’s best defence, and knowing you are holding robust and high-quality companies gives the conviction to deal with or even take advantage of any short interest.