Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 229

Ignore the rise of short selling at your peril

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 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 and shorting Healthscope, 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, and Quintis.

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, 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.

 

Julian Beaumont is Investment Director at Bennelong Australian Equity Partners (BAEP). This article contains general information that does not consider the circumstances of any individual.

8 Comments
Maurice
December 03, 2017

Graham
Every market quote screen should include a short-selling number

Split
December 03, 2017

Hi Stella,

I refer to marketindex.com.au and go to popular pages in the menu and ASX Short Sales data. It also has directors transactions which is also handy.

Stella
November 30, 2017

Hi
How and where on ASIC's website does one find the percentage of a company’s shares shorted?
Thanks

Graham Hand
December 01, 2017

Hi Stella, ASIC lists the shorts here: http://asic.gov.au/regulatory-resources/markets/short-selling/short-selling-reporting-short-position-reporting/

There is also an ASIC paper on shorting here:

http://www.asic.gov.au/media/1241087/rg196-short-selling-20110429-updated-asx200-to-asx300.pdf

Gary M
November 30, 2017

OK, agree should be aware of short selling, but hardly "at your peril" as in heading.

Ashley
November 30, 2017

Should mention that most (if not all or almost all) large super funds profit from stock lending to the short sellers. Without stock lending there would be no shorting, and super funds (and therefore their members, which is most Australians) have benefited from short sellers for many years.

Michael
December 01, 2017

How have super funds benefited from short selling? Sure they earn a fee from lending the stock but then they watch the price dropping as the short sellers take over . I can never understand why institutions lend stock knowing the purpose is to see a drop in the price and therefore a decline in returns to members. Some short sellers can be quite brutal in decimating a share price when fear and panic are rife denying a company the ability to raise urgent funding through a capital raising. Don't forget shorting was banned in some durisdictions during the GFC because of the devastating impact it was having on investors. The only people that should be able to sell shares are those that actually own them.

mikeh
December 01, 2017

I am not sure your statement "large funds benefit ..." is correct in all cases.

I am advised at least of one very large financial institutional trustee, of large public super funds, who lends " the legal ownership" and directly derives fees for the lending of the "legal" ownership.
I asked the obvious question on conflict of interest etc., which was not answered.


In this instance members are the beneficial owners and get no benefit whatsoever.

I hope this is isolated but as the lender and fee is not disclosed, who can tell ?

 

Leave a Comment:

     

RELATED ARTICLES

Market winners outperform losers again

Best-in-class, ‘pure-play’ companies give clearer focus

Single-period measures do not work for great growth companies

banner

Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates

Retirement

Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.

Property

Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.

Property

Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.

Shares

10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.