Short-selling bears feast on junior miners

Small miners are high on the short-sellers’ hit list.

Summary: The level of short-selling activity in specific stocks has increased, reflecting a view among the professional traders and sophisticated investors who engage in this activity that their target stocks are heading for a fall. Among the most actively short-sold stocks are small resources companies that are dealing with specific operational issues, or that are vulnerable to a broader deterioration in commodity prices.

Key take-out: Data shows that 3.18% of the stock available in the Small Resources index is being short-sold, more than double the 1.5% short-sold in the overall resources index.

Key beneficiaries: General investors. Category: Shares.

Not everyone is happy to see rising share prices. There are plenty of bears betting on future falls, and the place to see the bears at work is in the short-selling of a wide range of selected stocks, especially retailers, small industrials and resource stocks.

Short-selling is the process of selling a borrowed stock with the aim of buying it back later at a lower price to profit from the difference. Rarely mentioned in most stockmarket research, the work of short-sellers is highly specialised and closely regulated, but it’s also a useful guide to show most investors which stocks to avoid.

Whitehaven Coal (WHC), for example, is a short-selling natural, weighed down by the low coal price, project development uncertainty, and the major shareholder, Nathan Tinkler – widely seen to be seeking an exit route for his 20% stake in the stock.

With so much bad news it is easy to see why 17.1% of Whitehaven’s freely available shares are currently sold short, with sellers betting that the stock will continue to fall, creating an opportunity for them to buy back later and book a profit.

Over the past 12 months, short-selling bears have feasted on Whitehaven as its share price has plunged from a high of $4.64 last June to a low of $1.77 earlier this month.

It’s the same with another resource-exposed stock, the engineering and construction firm, Monadelphous (MND). Data published by the Australian Securities & Investments Commission shows that 12.1% of available Monadelphous shares have been sold short, a big increase on the 2.4% sold short 12 months ago.

The “bear raid” of the past year was fuelled by widespread reports of a sharp decline in resource-project construction activity and falling profit margins, which took their toll on the share price of Monadelphous. It has crashed from a peak of $28.48 as recently as February 18 to a low of $15.20 last Thursday.

Timing in short-selling, or knowing when to sell and when to buy back, is as important as conventional investing where the aim is to back equities that you believe will rise.

But there is an added complication for anyone interested in playing the short-selling game, and that is the need to locate a supply of shares available to be sold short. And that’s very much a place where the professionals play.

The process starts with a broker or well-heeled investor identifying a stock that they believe will fall at some time in the future. This is possibly because of a widespread trend, such as the commodity price downturn, or the impact of a disruptive technology such as the internet on traditional retailers and media stocks.

An approach is then made to owners of shares in the stock that is to be sold short, with a fee normally pitched at around 30 basis points to the price, or 3 cents per share on a stock trading at $10. That price will be higher if there is a shortage of stock available for short-selling.

Once assembled the sell orders are placed, with a good example of the timing gap involved available in data kept by the investment group Wilson HTM. The latest edition of its report titled “Short and Stocky” noted that more than 10% of Northern Iron (NFE), a company with a troubled iron ore mine in Norway, had been “borrowed” and was ready to the sold short (see chart below).

Source: Wilson HTM

The activity of the bears can then be tracked with ASIC’s daily report showing that 12 months ago 0.2% of Northern Iron was reported to be short-sold, rising to 0.7% by last Friday.

Given what’s happened at Northern Iron’s operations over the past month, the short-selling bears have just made their latest killing. Management reported severe problems in the iron ore processing circuit at its Sydvaranger mine, and the news knocked the share price down from around 31c in early May to 9.6c yesterday.

There are, obviously, big risks in short-selling. It involves investing in a thin market because there is generally not a lot of stock available, there is an initial fee to pay to the owner of stock being made available and, in the case of companies which pay a high dividend, that too must be replaced by the short-selling investor.

But as a tool which helps point to market trends, the activity of the bears can be quite useful. The major trends currently evident include the high rate of “shorting” small companies, especially in the resources sector, where research by strategist Damien Klassen at Wilson HTM shows 3.18% of the stock available in the Small Resources index is being short-sold, more than double the 1.5% short-sold in the overall resources index (see chart below).

Source: Wilson HTM

It’s a similar picture among small industrials versus the overall industrials market, where the small industrials index has been short-sold by 3.66% and the overall industrials index by 2.04%.

The short-selling among small miners and oil producers reflects the added pressure on companies that might not own a profitable producing asset and that face the challenge of raising fresh capital in a bear market to survive.

Examples of resource stocks high on the list of short-sellers, include:

  • Western Areas (WSA), a nickel miner battling a depressed nickel price. The short-sold position in its freely available (free-float) shares has risen from 6.1% a year ago to a current 10.2%.
  • Troy Resources (TRY), a goldminer in the middle of a takeover which some investors believe has been badly timed. Its short-sold position has blown out from 0.6% of free-float stock to 5.4%.
  • Paladin Energy (PDN), a uranium producer which has struggled to trade profitably because of high costs in a depressed uranium market. Its short-sold position has grown from 9% to 14.1%.
  • Iluka Resources (ILU), a zircon and titanium minerals producer also battling low prices and speculation that it might not pay a dividend next year. Its short position is out from 6.4% to 13.7%.
  • Fortescue Metals Group (FMG), an iron ore miner with high debt levels and high costs being buffeted by a falling iron ore price. Its short position is out from 6.6% to 9.5%.

A similar picture of bear activity can be seen among retailers under pressure from sluggish consumer spending and traditional media companies facing internet competition.

David Jones (DJS) and Myer (MYR) were singled out by short-sellers for heavy trading as speculation grew they would report poor trading results, with their short positions growing from 10% to 11.3% in the case of David Jones, and from 11.7% to 15.4% in the case of Myer.

Newspaper publisher Fairfax Media (FXJ) has been under a sustained bear attack, with its short position stretching from 12.6% to 19.5%, whereas internet-based job search group Seek (SEK), an arch-rival in the advertising market, has a short position of 3.9%, marginally higher than the 3.6% of 12 months ago.

Where the short-selling data can be interesting is in showing stocks that a well-informed sector of the market believes are heading for a fall. While not always correct, and short-sellers can be caught out by a burst of good news which makes their buy-back cost higher than what they sold shares for, it can be useful to see who is being singled out for negative reasons that management of the stock involved might not be talking about.

Klassen’s research has shown how stocks with US dollar earnings have generally been seen as winners, and therefore of less interest to short-sellers.

Brambles (BXB), for example, has seen its short-sold position decline from 0.8% of its free float to 0.2%, and Cochlear (COH) has fallen from a high 11.1% short-sold 12 months ago to 7.4%.

The big miners, with a heavy inflow of US dollars, are not as heavily short-sold as the juniors, which lack a similar exposure. BHP Billiton’s (BHP) short position has barely moved over the past year. It had 0.5% of the free float short-sold 12-months ago, versus 0.3% today. Rio Tinto (RIO) is down from 4.3% to 2.2%.

Providing short-selling data is a relatively new feature of ASIC’s work, with information only going back about three years. For anyone interested, here’s a link to what ASIC provides: (Click here and go to Quick Link Latest Daily (pdf)). For the latest Short and Stocky report from Wilson HTM, click here.

Included in the Wilson HTM report are tables that show weekly and monthly movements in short positions and a column headed “days to cover”, which is information professional short-sellers find useful because it shows the number of days of normal trade in a stock that would be required for short-sellers to cover their positions when they decide to sell.

In the case of Whitehaven there are 16.3 days to cover, a long time in the short-selling world and a warning that anyone short the stock could find it difficult to buy back quickly should the outlook for coal or the company suddenly improve.

For most investors there is limited appeal to indulge in short-selling. It is highly specialised, with its own language and nuances.

But, as a guide to the negative side of the market, it is a useful offset to the sometimes excessive optimism of stockbrokers.