Wednesday, 25 July 2018 14:43

Short Sellers - can they help retail investors avoid 'bombs'

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 DSC8761This article was written by Mark Draper and appeared in the Financial Review in the month of July 2018.

Mark writes a monthly column for the Australian Financial Review.

 

Good investors are rewarded for not just what they purchase, but just as much by what they let pass.  Could it be that much maligned short sellers could actually help investors avoid some of the stock market ‘bombs’.

Short selling is defined as the sale of a security that is not owned by the seller or that the seller has borrowed.  Short selling profits when the value of an asset decreases in price, enabling it to be bought back at a lower price.  By examining what short sellers typically look for as their targets can help retail investors avoid investment traps.

With this in mind I spoke with Andrew Macken, Portfolio Manager at Montgomery Investments who spent several years working with world famous short seller Jim Chanos.

Short sellers are sophisticated investors looking for weaknesses in businesses and business models.  Macken believes “there are 4 key characteristics that make a great short”.

  1. Structural decline at industry level.  These are structural headwinds within an industry that are likely to last for years not quarters.  Technological obsolescence is a good example of this characteristic such as video rental stores being disrupted by online content providers.
  2. Divergent Expectations.  This exists where market expectations built into the share price are overly optimistic.  Dominoes Pizza is currently one of the most heavily shorted stocks in the Australian market as short sellers question whether future growth may be at a lower level than what is currently reflected in the share price.
  3. Asymmetric risks.  This is when the downside risk is unequal, or greater than the upside risk.  These characteristics can lead to waking up one morning and seeing a share price down 30%. A stretched balance sheet is a good example of this, where one day the business is fine, and the next day the business fails to meet a debt covenant or refinance commitment.  Centro Properties was a high profile case study of this.
  4. Misperceptions.  These are instances of aggressive or creative accounting.  There are numerous ways in the accounting world that a business can be portrayed in a manner that is more flattering than the reality.  This can commonly occur during acquisitions where adjusting items such as goodwill can result in overstating future earnings. Fraud is the ultimate misperception. The Dick Smith IPO, which was labelled the “Greatest Private Equity Heist of all time” by Forager Funds Management is a classic example of a misperception and a detailed analysis on this can be found on their website.

Andrew’s ideal approach is to consider shorting companies that exhibit all four of these characteristics.

Those who own shares in a company that is being heavily shorted, means that sophisticated investors are flagging that some or all of these problems may exist in that company.  An increase in short selling activity could be an early warning signal that a problem exists.  So how can investors determine the level of short interest in a company.

ASIC provides a daily list of short positions on Australian listed companies on their website.  This information should also be available from a stock broker or financial adviser.  The information expresses how much of the company’s shares in percentage terms have been short sold.

Investors may be alerted to potential issues by watching trends of short selling activity and establishing whether the short positions are increasing.  

Clearly short sellers do not always get their calls right, just ask those who recently got burned being short in the Healthscope takeover offer.  But investors would be wise to keep an eye on short activity.  This could allow investors time to reconfirm (or otherwise) the investment case for a stock they own, or intend to buy, that is subject to material short interest.  As they say in sport, the team that makes the fewest mistakes wins, and maybe short sellers can help retail investors make fewer mistakes.

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