Short Selling Stocks: Not as Easy as It Looks

There are few things that attract the ire of public companies more than short selling. While they can find out after the fact, it’s hard for companies to determine exactly how much of their stock is sold short, or who is behind the selling.

While ASIC operates a short positions table on its website, it’s not without its limitations. As ASIC states:

It is important to note that ASIC’s aggregated short position reports are reliant on the accuracy of reports we receive from individual short sellers.’

That’s pretty clear — ASIC rely on the short sellers to fully disclose their positions. But, as ASIC notes:

While we monitor compliance with short position reporting and provide additional guidance where necessary, we are unable to verify the accuracy of all individual reports submitted to ASIC, nor to verify that that all short sellers in our market (both in Australia and oversees) are lodging reports.’

And that’s where the rub is. While there are funds that no doubt comply with ASIC’s guidelines, trying to quantify those that don’t report, or only do so partially, is a much harder deal.

While short selling has become common practice in the market, it’s something that goes against the grain for many investors.

Investors’ interests and those of a company’s management should be aligned. Both want the company to succeed; to grow profits and deliver a rising share price.

But it’s not all rosy. There can be plenty of conflict when institutional shareholders disagree with the direction a company is heading in. They can exert a lot of pressure behind the scenes to bring management back into line.

If the fund managers don’t get their way, they’ll push for changes in the board and management. If that fails, they’ll dump their shares and put their money elsewhere.

But short selling goes one step further. It involves taking an active position against a stock.

By short selling — that is, selling shares they don’t own in anticipation of buying them back at a lower price — hedge funds and traders aim to profit when a share price takes a bath.

Not such a big deal in other markets

For those who trade commodities and currencies, trading either direction of the market is of little consequence. They don’t have that long bias that is inherent in share trading. With shares, there is a bias (which is often wrong) that shares should increase in value over time.

But with currencies, this bias doesn’t exit. There is no reason that the Aussie dollar, for example, should increase against the US dollar over time. There are many layers at work, but a currency generally reflects the relative strength of a country’s economy.

And, similarly with commodities, there is no fundamental reason that coal or iron ore should be higher in the future than they are now. Both are in plentiful supply; the prices reflect the relationship between supply and demand.

Where the short selling of shares also differs from these other markets is that the seller needs to borrow shares from someone else to complete the deal.

Just like any other share transaction, a short sale needs to be settled on a T + 2 basis. The only way a short seller can hand shares over to the buyer is by borrowing them — typically a big institution, who collects a fee.

As bizarre as it sounds, an institution could earn a fee for lending shares to a short seller — the very same shares it manages on behalf of investors in a long-only fund. And that’s what raises the hackles of investors. The two parties have clearly opposing goals.

A hard thing to get right

Whatever opinion you have on short selling, it is here to stay. And it’s not as easy as it looks. Quite often, a stock is short sold when a fund believes it (or the sector it belongs to) to be overvalued on a basic metric, like a P/E ratio for example. Yet an overvalued (or expensive) stock can keep going higher.

And there are ways in which companies can defend themselves. For example, when Platinum Asset Management’s [ASX:PTM] share price was being driven down by short sellers this year, its management unexpectedly announced a share buyback. The stock jumped close to 14% in a single day, forcing the short sellers to scramble.

Many an international ‘expert’ has called the end of the property market and taken a short position in the banks. But with the upcoming Basel IV guidelines (capital requirements for banks) now looking less onerous than once thought — and bad debts not spiking as some have predicted — a lot of the negative sentiment has shifted away from the sector.

Short selling can work, but it’s hard to get right. Fortescue [ASX:FMG] — once of the most shorted stocks on the market — is now trading around four-and-a-half times higher than where it was at the start of the year.

And one thing is for sure: If you short sell a stock and it goes against you, you’ll be hard pressed finding anyone who’ll offer you any sympathy.

Ultimately, short selling isn’t for everyone. But there are some funds that trade both directions of the market at the same time. One of them is on the Total Income buy list and currently generates a fully franked yield of nearly 7%. You can find out all about it by clicking here.


Matt Hibbard,
Editor, Total Income

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Money Morning Australia