Mark Draper [12ft.io]ContributorFeb19, 2024 – 5.00amWhile short...

Mark Draper [12ft.io]Contributor

Feb19, 2024 – 5.00am

While short sellers are often regarded as practising a dark art, they are very sophisticated and investors can improve their skills by paying attention to what the shorters are up to.

Short selling is when an investor borrows shares and sells themon the open market with the expectation of buying them back later for lessmoney.

An obvious area where short sellers could be wrong is if thereis a sharp increase in the lithium price as a result of an uptick in demand.

Sean Roger, deputy portfolio manager at Perpetual, says that where there is a high level of short interest in a stock (expressed as a percentage of shares sold short), it reflects the view held by some hedge fund managers that the share price is goingto fall.

The reasons for being “short” include a view that the company isovervalued; will miss earnings expectations; has an over-geared balance sheetthat may result in a discounted equity raising; or has unsustainable earnings.

Hugh Dive, chief investment officer at Atlas Funds Management,continually reviews the market’s short positions.

If one of his fund’s investments appears in the top 10 shortselling list, this is a strong reminder to revisit the investment thesis asother smart market participants have a contrary view.

It doesn’tnecessarily result in selling the position, but it prompts a review to ensurehe is not missing something.

The most popular short theme at themoment is the lithium sector [12ft.io] and Pilbara Minerals is the most shorted stock on the S&P/ASX 100.

Roger saysthe reason for this is that the lithium price has fallenmaterially [12ft.io] over the past six months as the market moved from a metal deficit to oversupply.

This is as aresult of falling demand as electric vehicle penetration globally has slowed ata time when lithium supply has increased.

For lithium producers, this has resulted in a collapse in margins and cash flow. For pre-production assets, this puts pressure on future returns, exacerbated byincreased construction costs.

IDPEducation, an international education specialist, is the second most shortedcompany.

IDP has beenone of the great success stories over the past 10 years, but the shortpositions reflect the more challenging industry and competitive outlook.

The companyfaces increasing competition in its English language testing business in keymarkets of India and Canada, and the recently introduced restrictions inimmigration in Australia and Canada look likely to pressure student placementvolumes, says Roger.

Dive saysthe short sellers are not always right, but investors need to understand wherethey may be wrong.

Dive hasowned JB Hi-Fi since 2018, and it has been heavily shorted ever since then onthe basis that Amazon was going to destroy Australian bricks-and-mortarretailers.

JB Hi-Fidefied the short sellers by keeping prices low, operating efficiently, offeringproduct advice in-store, and taking market share from retailer Harvey Norman.

Understandingshort positions can also help investors understand large share price movementsthat can be caused by short sellers covering their positions.

This couldexplain part of the large moves in JB Hi-Fi recently as short sellers may bebuying back the shares they borrowed, on the expectation the worst may havepassed for the retail sector.

Roger flagswhere the short sellers could be wrong on Pilbara and IDP:

• With Pilbara, there is significant corporate interest in lithium deposits and, given the share price falls of lithium companies, a key risk in being short is that the company receives a takeover offer [12ft.io], which usually sends the share price higher. The other obvious area where short sellers could be wrong is if there is a sharp increase in the lithium price as a result of an uptick in demand.
• While increasing competition in English language testing looks likely to affect market share, IDP may continue to deliver growth due to sustained strong industry volumes. IDP is also under penetrated in the US market and any sign of gaining traction there would help offset any earnings pressure.

Reviewingshort interest in companies not only helps investors understand what is takingplace in markets, but can also increase their conviction in their owninvestments.