CPD: Shorts, long stocks and scandals

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Short selling in a stock can forewarn problems and price falls…

As unfashionable as it might be in some quarters, short selling has become entrenched as a legitimate trading strategy in Australia.

Investors should take note. Short selling in a stock can forewarn problems and price falls, although short sellers don’t always get it right. Ultimately, it is company fundamentals that dictate stock returns, and to this end, research is an investor’s best defence. Our advice: be alert, not alarmed.

Sell high, buy low

The usual way to make money from stocks is to buy low and sell high. Short selling works in reverse – the short seller hopes to sell high, and later buy back the shares low. It involves selling something you don’t own, made possible by borrowing the shares from the outset. Also unusual, short sellers profit to the extent the share price falls. Thus, they hope for the company to fail, not prosper.

Not to be sold short

For some, the whole exercise can seem a bit surreal. Short selling has, however, been around since the very early days of stock markets – apparently a short was made in the early 1600s on the first ever company, the Dutch East India Company1 – and shorting has now become entrenched as an accepted part of a properly functioning market.

Indeed, ASIC considers it “a legitimate mechanism for price discovery and liquidity”2. As examples like Enron attest, short sellers are financially motivated to uncover and expose problems at a company, which long-only investors can often miss, and which ultimately leads to a better informed market. Short selling has become increasingly prevalent in Australia in recent years. Short interest, being the percentage of a company’s shares sold short, has doubled on the ASX since mid-2010 when it was first officially tracked.

 

 

Why go short?

It is not always the case that the short seller foresees problems and expects the shares to fall. For example:

  • A popular hedge fund trade has been to short sell BHP on the ASX and buy the equivalent shares listed on the London Stock Exchange. The trade attempts to arbitrage the premium the former trades over the latter, and implies no real view on BHP.
  • A ‘pairs trade’ might involve buying Ramsay Health Care and shorting Healthscope, another private hospital operator. The trade is premised on a view the former’s shares will outperform the latter’s, regardless of whether their shares go up or down.

Commonly, short selling is used to provide downside protection within a broader portfolio. The idea is for the shorts to make money in a market downturn, thereby insulating the portfolio from the likely losses on the longs. By design, the short selling hedges out some or all of the equity market risk, with the effect of reducing both the downside and upside. Naturally, the investor seeks to short the worst stocks and go long the best, generally based on views of their relative rather than absolute returns.

On the short side, investors typically look for looming problems they foresee but that are ignored or dismissed by the market; rarely do they target companies on perceived overvaluation alone. Specifically, there are a number of key things they look out for (most of which were behind big short scalps like Slater & Gordon, Estia Health and Quintis). They include:

  • flaky or aggressive accounting, where real earnings fall far short of reported numbers;
  • weak cash flows;
  • frequent or outsized acquisitions;
  • indefensible business models;
  • regulatory funding and other pressures;
  • overly promotional management;
  • insider selling by executive and directors;
  • poor corporate governance;
  • the ongoing need for capital, requiring ongoing support from equity and other investors; and
  • excessive debt.

Some might presume short sellers benefit from the price decline that can sometimes result from the short selling itself – especially where the selling is aggressive – but the reality is this effectively unwinds when the shares are eventually bought back to close out the short. The marginal seller might be worse off, but long-term investors are unaffected.

Ultimately, short sellers must buy back their shares from someone. But only shareholders have shares to sell them, and these same shareholders held onto their shares at the higher prices the short seller originally went short. Without a change in view, they are presumably less reluctant to sell lower down. Thus, to make money from a short requires a shift down in the market’s assessment of the stock’s value. Generally, this requires problems to come to the surface.

Going short is a risky game

The risk-rewards are very much skewed against short sellers.

On any given short, they are up against the odds, and time is their enemy.

They start behind, handicapped by the ongoing costs of borrowing stock for the duration of the trade. These include interest costs, which accrue much like interest on an ordinary loan, with the interest rate typically around 0.5% on an annualised basis, but as high as 5% or even higher for in-demand stocks. In addition, the ongoing costs include payment in lieu of any dividends, including the value of any franking credits that shareholders would otherwise have received3. This can add up to additional ongoing annual costs of 8% or higher, depending on the company.

Short sellers then face an uphill battle, up against the tendency for stocks to rise higher over time. That puts short sellers up against the clock, with the need for short-term thinking and, ideally, deft timing. There are also risks in short selling as part of a broader portfolio approach.

  • The short seller’s hand can be forced. Similar to margin lending, short sellers must post collateral to support their loan, and post additional collateral or buy back the stock should the share price rise. This can give rise to a self-fulfilling “short squeeze”, where the buying pushes the shares higher, causing additional losses and requiring even more buying. Having your hand forced may mean you lose even if your short thesis subsequently plays out.
  • Opposite to a long position, a short offers a maximum return of 100%, which occurs if the share price falls to zero. However, potential losses are uncapped, reflecting the fact that the theoretical appreciation in the share price is unlimited.
  • Also in contrast to a long position, a successful short position gets smaller in one’s portfolio as the share price falls, and larger if the share price goes up. A short position that turns bad can become an oversized portfolio position and an outsized headache. In practice, risk management is required. For example, many hedge funds will set stop losses around a price rise of 15%. The upshot is to add greater complexity, more attention to risk management, and in the end, more distraction.

Short selling with aggression

Alongside the rise of short selling, it seems short sellers are increasingly willing to pursue more aggressive tactics in an attempt to get their way. Given the timing pressures and other risks involved, it is understandable that short sellers might want to push their case. Ultimately, they are trying to shake investors’ confidence in the targeted company, and to do so in fast measure.

Generally, short sellers operate from the shadows, seeking to influence things by employing tactics such as feeding negative snippets and news stories to the media and ‘reverse-broking’ their views to brokers. Despite some public perceptions, very rarely will they cross the line of the law4. More recently, short sellers, particularly from offshore, are taking an activist approach. This involves preparing research reports detailing their bearish thesis and making them widely available, with an example provided by the short attack on sandalwood producer Quintis5. As an observation, the short seller’s campaigns are becoming more persistent and increasingly coordinated; their barbs better researched and increasingly more personal; and the media appear more willing to engage, and in fact take carriage of the story. And as a result, it seems the short attacks are becoming more effective.

This is understandably causing angst among companies targeted. For them, the best approach in most cases is to do nothing. A defensive attitude, like the one taken by Gerry Harvey, will only add fodder to the fire.

“I think short sellers should be banned – when someone sells your shares [short] they have a huge incentive to go out there and demolish the price. If you are here, please get up and piss off.”
Gerry Harvey at Harvey Norman’s AGM in November 20166

Short interest in Harvey Norman stepped up following this comment, and coincidentally, more than doubled in mid-March around the time of a damning media article questioning the company’s exposure to franchisees’ loans and losses. The stock has fallen about 20% since immediately before the mid-March news article, and the short interest remains high, above 10% of the free float.

Sometimes, the targeted company will be forced to defend themselves. This might be by regulators – Harvey Norman was required by the ASX to respond to the allegations in the media article7 – but also by shareholders, who often feel similar angst and who also want answers. Often, the result is to put a blow-torch to the company, which generally comes with improved disclosure, shareholder communication and corporate governance. At this stage, it is important shareholders have done their homework and gained conviction in the strength of the company and its prospects.

What is the track-record of short selling?

One might presume from examples like Slater & Gordon, Estia Health and Quintis that the short sellers have it all their own way, and that we should therefore be scared when they get involved.

Most short sellers will of course celebrate their wins, talk little of their losses, and may leave the impression they are infallible. But short sellers, like all investors, never work with certainty their calls will work out, and often they don’t. As a case in point, the short sellers have quite consistently been wrong in shorting the banks. Contrary to what they’ve publicly argued, the housing market hasn’t crashed, nor have bad debts risen meaningfully. It’s been a costly trade – short sellers have suffered from bank shares going up as well as having to reimburse short lenders for the dividends paid – and it’s become known as the ‘widow-maker’ trade.

In our quantitative analysis of short selling, we found limited correlation between short interest and subsequent stock returns. Depending on the timeframe to judge returns, sometimes it was positive, sometimes negative. To give an example of the former, and as seen in the Appendix, the most heavily shorted stocks at the start of 2016 actually outperformed materially, on average, over subsequent periods and since.

The fact is there are more than 450 stocks that are currently shorted, including around 50 with a short interest greater than 5%8. All investors are bound to own stocks that are shorted, sometimes heavily so. Clearly, not all can perform badly. Ultimately, it is the company’s fundamentals – rather than the extent of any short interest – that determines investors’ returns.

Why we don’t short sell

We ourselves don’t short stocks; we are purely long-only investors. We focus our efforts entirely on the best quality companies, where we think it is easier to make good returns over time. It means we get to spend more time getting to know these companies better.

We have owned a number of stocks over our time that have been heavily shorted. Mostly, they have worked out in our favour. We are, however, ever-conscious of short sellers, and of the possibility they may be right and we are wrong. We seek to understand and test their views against ours. Extensive research is our best defence, focused as it is on the company fundamentals that ultimately drive investor returns.

A recent example: Flight Centre

Since about 2012, Flight Centre has consistently been one of the most heavily shorted stocks on the ASX. The short interest is 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 out-competing its competition. Flight Centre has been able to strongly grow its business, despite facing online competition for decades now. Indeed, it has been able to take market share, including in Australia, its most mature market.

 

 

In our view, the short thesis underestimates the breadth and quality of Flight Centre’s business and its management team. It:

  • has a focus on higher-end travel bookings through its various other formats such as Cruiseabout;
  • has online capabilities including online-only businesses such as StudentUniverse.com.au, the leading travel booking site for the youth market;
  • has its own travel products, such as Top Deck tours, and other travel businesses, such as currency exchange business Travel Money; and
  • operates the world’s largest corporate business.

All up, Flight Centre has about 40 different travel brands, and it arranges more than $20 billion worth of travel bookings globally each year.

Earlier this year, we bought up a substantial stake in Flight Centre, with short interest as high as 21% as we did. What prompted us to do so were signs of a renewed focus on cost discipline, something that has been missing for some years, and which we consider will now leverage the growth in travel bookings into strong earnings growth. It is unlikely that many of the short sellers recognised the cultural change we observed internally within the company.

Rarely do short sellers get the opportunity to engage with senior management, especially when they are known to be short their company. Since acquiring our stake, the company has upgraded their earnings guidance, reported a strong full-year financial result, and also announced a transformation program for the next five years. This program is focused on maintaining strong growth in travel bookings, cutting out unprofitable businesses, lifting under-performing businesses, and more tightly managing costs. The program comes with ambitious financial targets that, if achieved, imply very strong earnings growth and material upgrades to the market’s expectations for earnings.

In some respects, the short interest and the negative sentiment that accompanied it, fed through in a lower stock price and gave rise to the opportunity. The stock has returned more than 70% from its lows this year. Short interest has reduced significantly over this time, with the short’s buying possibly helping the share’s rise. Interestingly, over a longer time period, the graph shows that there is a mixed relationship between the share price and short interest in the stock.

 

 

Another example: Domino’s Pizza Enterprises

What about where the short sellers arrive on a stock you own?

We have owned Domino’s since 2012, when we first built up a stake at prices below $10 per share. While the stock has done well since then, the shares have faltered over the past year, down approximately 35% from highs in August of 2016.

In February this year, short interest in the stock started to step up. Coincidentally, it was then that the company started to come under quite public attack from the media, buy-side analysts and short-side investors. Among other issues, they questioned the profitability of Domino’s franchisees and pointed to cases in which franchisees were underpaying staff. Having researched these issues for years prior, we feel they have been vastly over-exaggerated by the company’s critics, and present only as short-term issues.

 

 

Meanwhile, the company’s operations remain on track and its earnings continue to grow strongly. Last financial year, the company grew net profits by 29%, and it has guided to around 20% for this upcoming year. We believe the shorts have put the blow-torch to the company, and it has stood tall. We also believe the market underestimates the company’s longer-term growth prospects, particularly in respect of the European business. While the shorts have pointed to a lofty PE multiple as evidence of overvaluation, we look further than just next year’s earnings for our guide. Indeed, we believe its earnings multiple will amortise quickly down over time as strong growth works to compound earnings materially higher. In this respect, we arbitrage our longer- term investing timeframe, looking for value beyond the purview of the short interest and other shortterm interest in the stock.

The company is currently the most heavily shorted of all the top 100 stocks on the ASX. While the future is never clear, we continually look to further our conviction around the stock, including continually testing out whether there is any merit in the arguments raised by the short sellers.

Conclusion

The takeaway for investors is to take note of but not fear short selling. Short sellers have shown some form in identifying disaster-prone companies and egging on their demise. But the evidence is they don’t always get it right. Far from it, with many in fact turning out to be among the best performers. Research is an investor’s best defence. Knowing you are holding truly defensible and high quality companies will give you the conviction to take advantage of or deal with any short interest.

 

 

 

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[1] See, for example, http://www.npr.org/2015/01/29/382463501/the-spicy-history-of-short-selling-stocks
[2] See ASIC Regulatory Guide 196, Short selling, April 2011. Note that only covered short selling, in which the short seller borrows the shares and therefore holds the shares in order to sell them, is legal in Australia. “Naked” short selling is illegal.
To explain price discovery, markets serve the real economy best when it prices stocks right, as this in turn means capital is raised and invested according to its merits. To this end, shorting allows non-shareholders to put their wallet on the line to express a negative view on a stock. This acts as a counterweight to the market’s dominant long-only bias. With short selling, anyone can both buy and sell shares; without it, anyone can buy but only shareholders can sell.
Less liquidity, or trading activity, increases the difficulty in which investors can transact, particularly at the price they want. ASIC’s bans on short selling through the GFC were found to have materially reduced liquidity in the market for the worse (see also ‘Has the short selling ban reduced liquidity in the Australian stock market?’, FINSIA Journal of Applied Finance, 2008).
[3] Borrowing ASX-listed shares from offshore saves you from having to also make good on the franking credits, as offshore shareholders don’t benefit from them, nor demand reimbursement in respect of them.
[4] Indeed, some might associate short selling with ‘rumourtrage’, smear campaigns and market manipulation. In rare cases, this may occur, but it seems to be a rarity. For all the
criticism that short sellers “short and distort”, the same can be said of those who “pump and dump”. Laws pertaining to market manipulation and false and misleading statements apply equally to short sellers and long-only investors.
[5] Glacius Research prepared a 39-page research report (and an 11-page follow-up) on the company that outlined its short thesis. Galcius sent these reports to analysts, the media and the broader investment community, and also made them publicly available on its website. For more, see https://glaucusresearch.com/wp-content/uploads/downloads/2017/03/GlaucusResearch-Short-TFS_Corp_QuintisASX_TFC_QIN_March_22_2017.pdf.
[6] See http://www.smh.com.au/business/cbd/no-harvey-it-isnt-shaping-up-as-a-happy-agm-for-gerry-harvey-20161113-gsofbs.html
[7] Indeed, regulators have started requiring that companies respond to short sellers’ allegations. See ‘Activists travel 16,000 kilometres to short Australia’, Australian Financial Review, 23 February 2017, http://www.afr.com/markets/equity-markets/activists-travel-16000-kilometres-to-shortaustralia-20170222-guj54s (link available to subscribers only).
[8] As reported as at 16 October 2017. See http://asic.gov.au/regulatory-resources/markets/short-selling/short-position-reports-table/.

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