Short selling harder than you think!

Over the past week short selling has been a hot topic in the financial press after a noted US-based short seller released a very negative piece about listed fund manager Blue Sky Alternative Investments (BLA). This caused BLA’s share price to fall 50%, wiping $440 million from Blue Sky’s market cap. Short sellers are frequently derided as vultures, rumour mongers or un-Australian. However, in practice, shorting stocks is a difficult, stressful and lonely way to make money in the market, which is predominately skewed towards good news and wearers of rose-tinted glasses.

In this week’s piece we are not going to look at the merits of Blue Sky as an investment, but rather at the mechanics and issues around short selling equities. We see that much of the coverage on short selling over the past ten days reveals that many of those who hold strident opinions on short selling have only a limited understanding of how it actually works in practice.

Step one: find a company with bad characteristics and a catalyst

In traditional long only investing the goal is to own good quality companies with honest management teams, clean balance sheets and solid future prospects. By contrast, when selecting a stock to short sell the desirable characteristics include companies with low or negative growth, high and increasing debt levels, a weak business model, over-valuation by a market, and possessing a shaky management team. However, a critical factor is the requirement for a catalyst; over-valuation or high debt in itself is rarely enough. In Blue Sky’s case it was the negative report from Glaucus. As very few investors have the luxury of lobbing a damming report from the sidelines and outside the regulation of ASIC and the ASX, we would look for events such as a potentially bad acquisition (preferably off-shore), heavy directors selling, or corporate turnover at management level.

Step two: Find the stock to borrow

Short sellers will then borrow stock from a stockbroker and sell it. They are essentially betting that the price of the target company will decline before they have to replace the borrowed shares by buying the stock back. This is often the step that is ignored in the financial press when talking about shorting a company’s stock, as it is wrongly assumed that investors can borrow stock to reflect their negative view on a company.

When borrowing shares to short sell an investor has to look closely at both the rate per annum that they are required to pay to borrow the stock, and where the owner is located geographically. The rate reflects supply and demand, and for most stocks is currently 0.5% per annum. For stocks where the shorting demand may be higher than the supply (such as Fortescue) the rate may be 15% or higher. In the case of small capitalisation or tightly held companies such as Blackmores, the short seller may be unable to borrow stock and thus cannot short sell.

In the case of Blue Sky, when we looked a week ago there was no stock available to be borrowed and the current short-sold position only represents 3 million shares, or 3.8% of the register. In a small and tightly held company such as Blue Sky most holders would not lend out their stock for short selling as to do so they would be providing short sellers with the ammunition to bet against their long position. For example, BigUN – which is currently suspended on the ASX in February due to accounting irregularities – only had 500k of their outstanding shares lent out to short sellers, which is a mere 0.3% of the register. In the lead up to BigUN’s suspension as its share price was falling, the demand to short this stock would have been intense, but there would have been no stock available to be borrowed.

Step three: Dividends and Corporate Actions

The short seller is required both to return the shares to the owner when requested, and also to pass on any dividends paid. We also strongly prefer to borrow stock from foreign owners such as large index funds like Vanguard or State Street, as if you borrow stock from a domestic owner and a dividend is paid, short sellers are required to compensate the original owner for both the dividend and any associated franking credits.

What happens if the stock goes up?

If the short stock rises sharply, the lender will be required to give their broker additional collateral, or the broker will require the short seller to close out the short sale transaction before the planned timeframe. A series of urgent requests to wire cash to your margin account to cover a short-sold stock that is rising sharply will test the mettle of even the most hardened short seller. In contrast, a long only position in a falling company can mentally be filed in one’s bottom drawer until it eventually comes good (or goes into administration).

This gives rise to the skewed payoff ratio from short selling, where the maximum gain is known (the stock falls to zero), but the maximum loss is theoretically infinite.

The Market can remain wrong longer than you can remain solvent

It would be wrong to view that short selling risky stocks is a smooth path to outperformance. Keynes, the father of modern macroeconomics, once famously said that “markets can remain irrational a lot longer than you and I can remain solvent’’. This quote particularly resonated with me after an unprofitable short selling of Fortescue prior to the GFC due to concerns about the over-valuation and debt situation of the company.

This trade was put on at $50 per share late 2007 and then was closed out at $70 four months later as the price continued to rise with no signs of slowing momentum. It was very painful to lose 29% in a short stretch of time; however, Fortescue peaked at $120 in June 2008 before falling back to $20 in December 2008. Whilst our investment thesis was ultimately correct, we were unable to handle the pain of a steeply rising stock and the associated unrealised losses and increasing margin calls.

Short squeeze

A “short squeeze” occurs when a heavily shorted stock rises sharply, forcing sellers to close out their position by buying back stock, thus causing further upward price momentum. Often when the market appears to overreact to a small piece of positive news, this is a short squeeze and it is similar to too many people trying to fit through a door.

For example, if JB-Hi Fi (currently 17% of the register have been “borrowed” by short-sellers anticipating that the price will go down) or Domino’s Pizza (18% of short) were to receive a takeover bid, the price would escalate sharply as short sellers look to cover their positions. A nightmare scenario would be a contested bidding war if you are short. In December 2017 we saw a short squeeze in Westfield when a bid from Unibail-Rodamco came through. However, unlike Dominos or JB Hi-Fi, the percentage of the property trust’s outstanding shares that we sold short was not a large amount, though we did see a spike in the share price that reflected the short sellers buying back stock to exit their positions.

Our Take

While short selling is often criticised and retains a negative connotation in a securities industry that is inherently biased towards optimism, we see that it serves a valid role in financial markets. Short sellers provide an alternative view and can aid both liquidity and price discovery in stock markets. In coming years – with MiFID II (new European regulations on stockbrokers) reducing the incentives for the investment banks to put out negative research and the decreasing value placed on sell side research – shorting will provide an alternative view. 80% of calls are buy or hold!

Investors should not look at situations like Blue Sky, BigUn or Slater and Gordon and view that it is an easy way to make money, nor that it is unfairly ganging up on a company. Even very experienced and adept short sellers such as Glaucus have made mistakes. For example, its shorts on Japanese trading house Itochu would have cost the fund manager substantially, with the price up +43% since they released their report in mid 2016.

Neither the Atlas High Income Property Fund nor the Maxim Atlas Core Australian Equity Portfolio currently employ shorting as an investment strategy. However, the author has previously managed a long short fund and has some understanding on short-selling as an investment strategy.

Monthly Newsletter March 2018

In March the listed property sector was effectively unchanged, a solid outcome in a month when the ASX200 declined by -3.8% and equity markets globally fell between -2% and -4% on concerns about a potential Trump trade war and rising tariffs.
The Atlas Fund declined slightly by -0.24% in a month were Listed Property effectively sat on the sidelines and ignored market volatility.
We see that after the pull back in early 2018, the listed property market is offering investors some interesting opportunities with a range of trusts offering stable distribution yields between 6% and 7% and are trading at discounts to their net tangible assets. In this environment we would expect management teams to be looking at initiating on-market share buy-backs.

Go to Monthly Newsletters for a more detailed discussion of the listed property market and the fund’s strategy going into 2018.

Splitting up with Coles, 1+1=3?

On Friday morning Wesfarmers announced that they are looking to demerge its Coles division to create a new ASX top 30 company, with leading positions in supermarkets and liquor. This move was very well received by the market, with Wesfarmers stock finishing up $2.60 or +6.3% on Friday, and over the weekend we have seen analysts upgrade their price targets for Wesfarmers.

The stated aim of this action is to reposition the Wesfarmers portfolio into businesses with higher growth prospects. Given Coles’ size and the concentrated market structure of the Australian grocery industry, Coles is likely only to grow at a rate similar to Australian GDP. In this week’s piece we are going to look at the Wesfarmers deal, and in particular at the rationale behind spinning out assets to form a new company. Typically, CEOs are incentivised grow rather than shrink the size of the businesses they manage.

The Deal

Wesfarmers are proposing to demerge Coles into a stand-alone ASX Top 30 company, and existing shareholders will then own shares in both Wesfarmers and Coles. Shareholders will get a chance to vote on this action later this year with the deal expected to close in FY2019. The new company will consist of Coles and Liquorland, and Wesfarmers will retain a 20% stake in the newly-listed Coles as well as Bunnings, Kmart, Target, Officeworks, Flybuys, and the industrial and chemical companies. Critically, management expect that the distribution of Coles shares to WES shareholders will likely qualify for demerger tax relief.

Why are management doing this?

Coles operates in the highly competitive domestic food and liquor business and going forward their growth will essentially track Australian GDP growth. Currently Coles holds 33% market share of Australian supermarket spend and 16% of retail alcohol sales. Realistically it would be very hard for Coles to increase their market share meaningfully in either of these categories without provoking an immediate reaction from competitors Woolworths and Aldi. Fundamentally Coles is a stable, low growth mature business.

People more cynical than us might look at remuneration conditions for senior management in the Wesfarmers Annual Report and notice that a large portion of the CEO’s bonus is tied to delivering a high RoC (return on capital) and note that removing Coles could make it easier to hit those targets. For example, in the last six months, Coles delivered a RoC of 9%, whereas Bunnings Australia had a RoC of 47%! However, these bonus conditions may be adjusted to reflect the split.

1+1 = 3 ?

Prior to Friday’s announcement Wesfarmers had traded on a lower price earnings (PE) multiple that Woolworths, so spinning off Coles is expected to deliver a valuation uplift to shareholders. Assuming Coles trades on the same multiple as Woolworths the new company would be worth $22 billion. Prior to the announcement using an EV/EBIT (Enterprise Value divided by Earnings before interest and tax) multiple, the implied value of Coles was $18.5 billion. The uplift to shareholders from the announcement can be seen in the $2.9 billion lift in Wesfarmers’ market capitalisation on Friday.

The ignored child gets a new lease on life

The most common reason cited for a company demerging or “spinning off” a division into a separately listed vehicle is that the previously unloved division will now be run by management totally focused on it. The theory goes that as a result of this increased love and focus and not having to compete with other larger divisions for management attention and capital, the demerged division begins to prosper. Furthermore, management at the parent company benefit, as the more attractive “core” business is now re-rated upwards by the market and valued on a higher multiple. The sum of the two parts becomes greater than the original whole. We see this as one of the motives behind Wesfarmers spinning off Coles.

Recent examples of this type of strategy can be seen in Orica’s 2010 spin off of their paint division Dulux, Woolworths spin-off in 2012 of a portfolio of shopping centres into Shopping Centres Australasia Property Group, and BHP’s spin off of S32 in 2015. These three spin-offs have proved to be very successful with Dulux giving shareholders a total return of +251% vs Orica’s loss of -2%. Similarly Shopping Centres has returned +89% since it was spun out of Woolworths in 2012, against a total return to Woolworths shareholders of 12%. In May 2015 BHP demerged S32 to separate the core iron ore, oil, copper and coal assets primarily located in Australia, Chile and the US from the smaller aluminium, Columbian nickel, South African manganese, silver, and South African coal assets. Since listing, S32 has returned +50% to shareholders vs BHP’s gain of +9%.

From meeting with the new management teams of the above companies post their demergers, it was clear to me that they exhibited a great deal of pride in the results of their own smaller companies and relished controlling their own destiny outside the larger parent. Furthermore, as stand-alone companies both Dulux and S32 were able to make decisions to grow their businesses, moves that probably would not have been approved if they were still competing for capital with BHP’s and Orica’s much larger Australian mining and global mining services.

Getting rid of a problem

Whilst the above more recent spin-offs have all outperformed their parents, there have been situations where a company demerges less desirable businesses that they see might hold back the core business in the future.

BHP has previously spun off divisions in the past that they viewed as less desirable. In 2000 BHP demerged their long steel division (Arrium née Onesteel), and in 2002 their flat steel division BlueScope Steel. This was motivated by the view – which proved to be correct – that greater returns could be made from digging ore out of the ground and directly shipping it to China, rather than in manufacturing commodity steel in Australia. Furthermore, BHP was able to “spin off” the industrial relations headaches that are present in the heavily unionised steel manufacturing sector. Whilst BlueScope is currently performing well after some near-death experiences in 2011 and 2012, BHP’s long steel business Arrium went into administration in 2016.

Similarly, Amcor’s demerger of its paper low growth business PaperlinX in 2000 removed a significant management headache for the global packaging company, as the growth in electronic communications and data storage has caused a structural decline in the paper business.

Our take

Whilst the above suggests that spin-offs can unlock hidden value for shareholders, there are potential downsides. Running two separately listed companies results in Wesfarmers shareholders bearing additional costs of maintaining two separate listings on the ASX , such as two separate boards and management teams. The most consistent winners from spin-offs are the investment banks. BHP paid US$115M in fees to create South32 and the investment banks would be expected to earn similar fees from Wesfarmers.

Themes coming out of Reporting season

Last week saw the end of reporting season for 180 of the S&P/ASX200 companies and around 2,000 of the companies listed on the ASX. Over the past month, these companies revealed their profit results for the six months ending December 2017 and provided guidance as to how they expect their businesses to perform in the upcoming year.

Whilst listed companies are required under the ASX’s continuous disclosure requirements to update the market when they become aware of new information that would impact their share price, reporting season always brings positive and negative surprises. In this week’s piece we are going to run through the key themes that have emerged over the last four weeks.

Few unpleasant surprises
The February 2018 reporting season was a pretty solid for Australian listed companies, which reported aggregated earnings growth of +9.5% and – more importantly – a sunnier than expected outlook for 2018. After being down -3.5% at one stage earlier in February, the ASX200 finished +0.4% on improving Australian corporate profits. This result was a significant outlier when most developed countries’ markets finished down between -3% and -5%. Across the ASX100, 33% of companies delivered results ahead of market expectations, with only 15% failing to meet expectations.

Having listened to close to eighty management presentations over the past four weeks, the general tone was observed to be more positive towards the future than it has been in recent years. This attitude was at odds with the doom and gloom coming from the share market. Positive views of the future can be seen in the 2% improvement in aggregate guidance for companies for profit growth of +5.8% over the next 12 months.

Give me my money back!
Capital management was a feature of the recent reporting season, which was understandably popular with investors. New buy-backs were announced by Rio Tinto, Lend Lease, Mirvac and Dexus. QBE Insurance reiterated their commitment to their buy-back. However, looking deeper into QBE’s balance sheet leads one to question the company’s capacity to conduct this buy-back. See Does QBE have the capital for their buy-back? Counter to this trend, APA Group and Woodside had shareholders reaching into their pockets, timing large capital raisings with the release of their results to fund growth projects.

At a dividend level Woolworths, Alumina, BlueScope Steel, ASX and Perpetual rewarded their investors with dividends ahead of expectations. Across the ASX, dividend growth for 2018 is now expected to be a relatively modest +2.7%, though this number is skewed by the -29% cut in market heavyweight Telstra’s dividend.

Across the ASX the dividend pay-out ratio remains high at close to 80%. Increasing dividends and buying back stock boosts share prices in the short term and may allow some management teams to achieve share price hurdles related to their bonuses. However, in the longer-term companies do need to retain cash to reinvest in their operations in order to grow. Contrasting with the ASX’s high payout ratio is the lower 51% dividend payout ratio of the US’s S&P 500.

Rock diggers good, but is this as good as it gets?
The miners reported solid profit growth in February, but this was expected as they continued to benefit from elevated commodity prices courtesy of the tail end of a Chinese stimulus plan from late 2016. Rio Tinto, BHP and Alumina reported strong profit growth, whereas Fortescue reported falling earnings and cut its dividend. Over the last year buyers have had a strong preference for higher quality iron ore due to Chinese moves to limit damage to the environment, which has pushed Chinese steel producers to use higher quality iron ore. Consequently, Fortescue’s lower quality iron ore has attracted discounts of up to 40% compared to BHP and Rio Tinto’s higher quality product.

On the conference calls to investors, management teams from the mining companies promised to maintain capital discipline, pay down debt and not waste the windfall of temporarily higher commodity prices, which was positively received by shareholders. What concerned us was the evidence of rising costs apparent in the results of BHP, South32 and Rio Tinto. We are concerned that over the next year the mining companies could face costs moving higher (particularly labour) at a time when commodity prices are weakening as Chinese stimulus measures fade. Our concerns around rising labour costs were exacerbated by the news in March that the Fair Work Commission approved the merger of the Construction, Forestry, Mining and Energy Union (CMFEU) and the Maritime Union of Australia (MUA) to create a 144,000-member super union.

Banks and their pound of flesh

Whilst the banks performed well during the reporting season, largely because they are viewed to be a beneficiary of rising interest rates and continued low levels of bad debts in the Australian economy. Commonwealth Bank reported cash profits of $4.87 billion in a result that was not easy to analyse due to estimates of a potential anti-money laundering fine and costs surrounding the Royal Commission. What seemed to be ignored by the market was that Commonwealth Bank expanded their net interest margin over the last six months, with repricing of their home loan book more than offsetting the much-decried bank levy. In their quarterly updates NAB, Westpac and ANZ all reported low bad debt charges and generally favourable business conditions. We see that the banks are well placed to have a good 2018 as the repricing of their loan books will drive revenue growth and low bad debt charges.

Best and worst results
Across the results presented last month, the best was delivered by CSL, Qantas, Flight Centre, A2Milk, IAG, Origin Energy and ResMed. The common theme among these companies was management’s ability to keep costs under control, while growing revenue at a rate well ahead GDP growth. Aside from the stratospheric growth rates achieved by milk producer a2 Milk in penetrating the Chinese infant formula market, the highlight for Atlas was CSL. It is very unusual for a company of CSL’s size ($70 billion market cap) to grow profits to the extent that it was able to do over the past six months, with profits up 31%. CSL achieved this due to increased sales in higher margin specialty biotherapeutics and their influenza vaccine business swinging from a loss to a healthy profit. CSL was criticised when a large part of the loss-making flu vaccine business was bought from Novartis in 2014 for US$275 million, however this business made US$185 million over the last half.

On the negative side of the ledger Vocus, Harvey Norman, Domino’s Pizza, South32 and Suncorp all reported disappointing results compared with other companies. The common themes across this group included either high price-to-earnings rated companies not delivering on high expectations, and companies that reported lower profit margins as management struggled to contain cost growth.

Our take

In contrast to other reporting seasons, this one was a relatively benevolent one for quality-style investors; who generally eschew high priced growth stocks and companies with issues such as Vocus. After falling market aggregate earnings in recent reporting seasons, this reporting season provided evidence that company profits are rising again and that profit margins are rebuilding. Whilst we expect the financials sector and stocks with offshore earnings to have a solid 2018, commodity prices (which we expect to weaken) should dampen ASX earnings for the remainder of the year.

Monthly Newsletter February

In February the listed property sector was sold off -3.3%, following global markets that finished down between -3% and -5%.
The Atlas Fund returned -2.7%, in a month where there were the share prices of most trusts fell regardless of their asset quality or even management upgrading guidance!
Against the doom and gloom on the share market, the February reporting season revealed that the actual economy is performing quite well. Over the last six months, the trusts held by the Fund delivered an average weighted increase in profits of +5.1% and and increased their distribution by +3.1%.
Whilst Atlas can’t influence the day to day share prices, what we can control is having the portfolio populated by trusts with secure distributions supported by recurring earnings and are growing ahead of inflation. Over time companies that are able to consistently grow the returns to shareholders will be rewarded by rising share prices, whereas those with unstable earnings inevitably languish.

Go to Monthly Newsletters for a more detailed discussion of the listed property market in February and the fund’s strategy going into 2018.