Short-selling gold signals

The trend in short-selling activity often gives an early signal on the direction of share prices. So investors should sit up and take note of the recent sharp changes in short interest among emerging stocks.

These changes in short positions, which refer to the selling of borrowed stock by traders betting on a share price decline, come amid the flood of earnings news and threats of escalating violence in the Middle East.

The sector that has recorded the most significant change in the short-selling trend over the past month is gold equities, according to the latest figures by the Australian Securities & Investment Commission (ASIC), which are a week old.

The data showed that short-sellers were buying back stock to close a significant number of short positions in Regis Resources (RRL), Saracen Mineral Holdings (SAR), Medusa Mining (MML) and Papillon Resources (PIR). These stocks are among the top 20 names that have seen the greatest reduction in short positions.

The 19% rebound in the gold price over the past two months is the key driver for the change in sentiment towards the embattled sector, as there is growing confidence that the free-fall in the spot gold price from October last year is over.

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Short-sellers must be sweating as the gold sector has been their favourite playground after doubts emerged about the asset’s ability to hold its value in the economic turmoil.

But gold has not only remained above the support level that is defined by the average cost of production (it is estimated that a gold price below $US1,000-$US1,200 an ounce would force major gold miners to cut back significantly on production, leading to a shortfall in supply), some believe a United States-led military intervention in Syria would push the precious metal significantly higher.

I believe gold has found a floor since hitting a low of $US1,200 an ounce in late June, but don’t hold your breath for a quick gold spike on a US strike, if history is any guide.

Looking at the past three significant US conflicts in the region – operation Desert Storm to free Kuwait in January 1991; operation Enduring Freedom to rid the Taliban from Afghanistan in October 2001; and operation Iraqi Freedom to oust Saddam Hussein in March 2003 – gold rallied in the days before the first US bombs or missiles are released, but the start of the campaign can prompt profit taking.

Any expansion of the warfare in Syria will not guarantee a higher gold price. The only real certainty is volatility.

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I don’t think we will see much of a sell-off in gold as the commodity looks to be well supported on dips, but if the yellow metal moves higher in the coming months, it will probably be driven more by a slower-than-expected tapering of the US Federal Reserve’s $US85 billion a month bond buying program instead.

The wind-back of short positions adds to the argument that things are looking brighter for gold equities, as WilsonHTM Investment Group strategist, Damien Klassen, believes short sellers tend to get more of their trades right than wrong.

“You hear about the notable failures more than the successes, as there is a powerful narrative when the short-sellers do get squeezed (or forced to close positions as the stock moves against them),” says Klassen.

“It is more expensive to ‘short’ a stock than to [buy] a stock, so there is a higher conviction when somebody goes short as they are paying for the privilege.”

He highlighted Australia’s largest listed gold producer, Newcrest Mining (NCM), as an example. Klassen recommended investors sell Newcrest before the June sell-off, as it went from being the least short-sold stock on the S&P/ASX 100 to the average in just a couple of weeks.

There are two key things in the short-selling data investors should watch, adds Klassen. The first is the absolute amount of stock that is short-sold.

“The other is changes in the direction and trajectory [of short interest] and I think that has actually been a bigger influence [on share prices],” he says.

Beadell Resources (BDR)

While Saracen Mineral saw the biggest reduction in shorts among Uncapped 100 stocks, with the percentage of short-sold stock to total shares falling 1.43 of a percentage point over the month to 2.12%, the gold miner that I find more interesting is Beadell Resources (BDR).

The proportion of shorts in Beadell may have fallen a more modest 0.7 of a percentage point since July 22, but the drop is significant as Beadell is the second-most shorted gold miner on the ASX. This means a relatively small percentage change in shorts would translate to a relatively large number of shares being bought back by short-sellers.

Further, I suspect it is getting harder for short-sellers to borrow Beadell stock. According to ASX data, the amount of Beadell stock that is currently shorted stands at 76% of the total stock available to short-sellers. The amount of stock available is different for each company as it depends on how much stock institutional investors are willing to lend out.

Based on the average daily turnover of Beadell stock, it would take short-sellers 10 days to replace the borrowed stock, and all these factors mean Beadell is in a good position to enjoy a short squeeze, where short-sellers have to rush to buy the stock, which forces the price up.

It takes a brave trader to open a fresh short position on Beadell under these conditions, especially when the factors that have made the gold miner such a favourite short target are easing.

Beadell’s financial health had been under a cloud due to debt and unexpected delays in mining its Duckhead deposit at its Tucano mine in Brazil.

The miner needs to sell gold from Duckhead to repay debt, with $US7 million due next month and $US32 million due by end of the calendar year. Beadell has a further $US62 million it needs to repay in 2014.

However, Beadell reassured investors yesterday with news that mining at Duckhead has started, and if all goes according to plan it will have little trouble repaying debt and will start delivering a sustainable dividend next year.

I believe the stock will be re-rated when it closes in on that important milestone, even though the stock has already jumped 73% in the past two months and is closing in on the average broker price target.

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I highlighted Beadell on May 29 as one of the stocks in the Uncapped 100 facing a game-changing year in 2013-14 and the stock has surged 36% to 88.5 cents since. I think the stock is still worth buying at current levels for a few reasons.

First, 60% of its gold output in the 2014 calendar year from Tucano is hedged at $US1,600 an ounce, which is well above the current gold price. Tucano is a long-life asset, with an estimated life of around 10 years.

More importantly, Tucano is a very low-cost mine. Cash cost is estimated at under $US500 an ounce, and while management has not provided total sustainable costs, I believe a gold price over $US1,000 will give it a comfortable margin.

There is good exploration upside potential too, and the stock is also cheap given that its enterprise value to gold assets of $178 an ounce is less than half that of it global peers.

eServGlobal (ESV)

On the flipside, mobile payment solutions company eServGlobal (ESV) has seen a big increase in short interest over the past month.

Traders may be betting against the company on the back of growing geopolitical tension. It is not only Syria but the civil unrest in Egypt that could drag on company profits, as Africa and the Middle East account for around 70% of group revenue.

eServGlobal’s Paris-based chief executive, Paolo Montessori, said in an emailed statement to Eureka Report that the company has been busy diversifying outside the region and played down suggestions that its revenues could be under threat.

“In regards to Syria in particular, our customer here has paid for the maintenance in full and we do not project any requirements for upgrades/expansions, nor are we forecasting any,” he says.

“This is the same situation for our customer in Egypt. Our customers are continuing to pay maintenance, which we manage via remote connections.”

eServGlobal is one of the more exciting small caps to watch as it has achieved critical mass with 1.2 billion subscribers in developing and emerging markets. The company also looks poised to return to profit in 2013-14 for the first time since 2008.

However, I believe investors should wait for a better entry price based on four assumptions. The first speaks to the fact that the stock has surged 132% to 44 cents over the past 12-months and looks to be losing momentum.

Technical analysts would also point out that the stock is hitting its head against key resistance at around 46 cents. The stock has tried and failed six times over the past year to break above this level.

The third is the increase in shorting activity, and shorting interest could persist for a while yet. Lastly, a fair amount of good news appears to be already factored into the share price as the stock is trading on a 2013-14 price-earnings multiple of 44 times.

I won’t be surprise to see the stock consolidate around the 35 cents to 40 cents level before breaking higher. Watch this space.

Think big, go smalls!

Brendon Lau does not own shares in BDR or ESV.

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