A major factor in the Australian and international sharemarket recoveries was that the shorters were buying back their stock.
One of the biggest, if not the biggest, factor that created the severe downward market thrust was the massive selling of stock not owned by traders -- so-called ‘shorting’. I alerted readers to this phenomenon in my market commentaries during the correction: (Why Australian share prices are falling, August 24 and The two sides of the sharemarket slump, August 25).
When markets turned upwards, they needed to buy back some of the stock they had shorted, thus propelling shares upwards. But in New York, in an ominous sign, the selling resumed, sending the market downwards.
In many markets, including Australia, these traders have special pipes into the market so that they can see selling coming and short stock in advance of it arriving. It’s a form of legal market rigging. In Australia the big superannuation funds lend the shorters share scrip in exchange for fees but they use that borrowed scrip to slash the value of Australian superannuation savings. The ethics are questionable to say the least.
Meanwhile, the fact that so much buying was created by shorters buying back means that we are likely to have further falls before this correction is over.
No company in the world is more vulnerable to the actions of shorters than Fortescue.
Global share traders have discovered that Fortescue is a wonderful stock to short sell if you have a bearish view on China. Fortescue is a pure iron ore play with large amounts of borrowing, albeit long term borrowing.
When the KGB interviewed Fortescue chief executive Nev Power (the interview will be posted to Business Spectator later this morning) he explained just how shorters had decimated his share price and he longed for a situation where they would be taken to the cleaners.
The interview was recorded before trading started yesterday. When trading opened, Fortescue shares started to rise which forced the shorters to cover their positions. This buy back helped propel the stock upwards and by the end of the day Fortescue was up 11 per cent.
Nev Power had a big smile on his face but he knows that the next time sentiment turns against China the shorters will be back.
Power explained that when he set up Fortescue’s long-term debt structure he made sure there were no covenants that could trigger an early redemption of debt. Some borrowing agreements contain clauses that state that should the share price fall to a certain level, the debt is repayable.
Anyone with that clause is very vulnerable to a shorting attack. In the interview I twice asked Nev Power whether his chairman Andrew Forrest had debt on his shares and whether that debt had covenants. On each occasion Power said he couldn’t answer.
My guess is that, like most entrepreneurs, Andrew Forrest maintained his 25 per cent plus stake in the growing company with the help of borrowing and I also suspect he would have been very grateful for the $15 million or so that he will receive in dividends as a result the latest Fortescue payment. That dividend will pay a lot of interest.
Fortescue is a remarkable company because it has built up infrastructure in both its rail and ports which gives it lower costs than its neighbour BHP. But BHP does very little processing of its ore. It simply digs it up and ships it out. Fortescue not only has to upgrade its iron ore but Fortescue ore is also sold at a small discount. It therefore has to be very efficient in the use of its infrastructure.
In theory, Fortescue could repay its debt by selling all or part of its rail and port infrastructure. But as Power explained, to get a very good price for the infrastructure Fortescue would have to guarantee generous rental payments which in turn would affect the profitability of the company. That lessens the group’s flexibility to capitalise on the value of its infrastructure assets.
If Fortescue does need to raise capital, it will need to be arranged by selling part of its mines, probably to the Chinese. While BHP and Rio Tinto are the two largest iron ore suppliers to China, Fortescue and Brazil’s Vale are third and fourth. The Chinese will not want either to fall over.
In the case of Vale, it is close to commissioning substantial new low-cost iron ore facilities. Fortescue hopes that rather than flooding the market with more ore, Vale will shut down its high-cost iron ore mines so that the total amount of ore in the market is not greatly changed.
Nev Power believes that if the China situation deteriorates, the Chinese will stimulate their economy via capital works. And longer term they still have 300 million people to urbanise and that will require a lot of steel.
FMG Price at posting:
$1.82 Sentiment: Buy Disclosure: Held
(20min delay)