MSB Trading - 2019, page-62

You guys ask seemingly simple questions, but the answers are complex, particularly on the effects of shorting.

Last I looked the amount available for shorting had gone back up to 1.8m, but I'm on holidays at present and trying to stay clear of the market. That is still a very low number (0.36% of MSB's capital), but if sold in a manipulative way, while peddling negative rumours, has the ability to push this thinly traded stock around.

At present however, the news is good, with the prospect of more good news to come next week. So it is very difficult for the shorts to be able to scare people in front of that announcement. If people aren't scared, it's harder to manipulate prices lower.

So the shorting pool is a little above the lowest level I've ever seen, but It would be far more worrying to see SI or M&G etc put their shares in the pool for shorting - each of them hold around 69m shares. I see no evidence of this and I think it is much smaller holders schnippling away. Each time they lend stock, then it has to be shorted, bought and possibly re-lent, however to the extent that retail buyers buy the shorted stock it probably doesn't re-enter the pool. This process all takes time and slows the velocity of the shorting.

The net shorts have dropped back below 8% as of Dec 28 - dropping from a 3- year high of 40.229 million shares net short (8.09% of company) to 39.0 million net short (7.84% of company).

Of course the corporate review came out on 28 Dec and seems to have put a bit of a scare into the shorts - and it may not be coincidental that there was short covering reported on Dec 28 (though previous bouts of good news have sometimes seen shorts continue to increase, often after waiting to see the high and then coming back and hitting it again). It may be that even after jumping from $1.01 to $1.21 on 28 Dec that the shorts think the price is still low on a historical basis and that the jump in the price isn't yet enough to ramp up their shorting - also with more news to come in San Fran on 7 Jan (2pm Melbourne time) it may be dangerous to aggressively increase the short here.

Since that drop in shorts on 28 Dec, daily gross shorts have not shown any new problems compared to their average daily 197,000 gross shorts in the past month - 116.000 on shortened 31 Dec trade and 125,000 on holiday affected 2 Jan and 208,000 yesterday.

The drop on Dec 28 could be a one-off and it could rebound tomorrow (as it often does). Remember if is all self-reported and probably somewhat manipulated. However, it makes sense to me that they wait until 7 Jan and another possible price spike.

The average daily gross shorting for the past month has been 15.3% of average daily volume - which doesn't look dramatic (roll back 2 weeks earlier and it was 14.4%) - but I suspect at least half the day's volume is churn (some of the gross shorts are also churn), so shorting could be as high as 30% of volume as an average and up to 50.5% reported on a raw basis on 27 Dec. Note that net shorts increased by over 2 million shares on the two trading days Dec 24 and Dec 27 - so maybe a bit of sellers remorse on Dec 28 when the Corporate Review came out.

The (voluntarily reported) net short position can keep rising because the same stock is being recycled, but the short pool effectively can stay the same if buyers are buying more and re-lending it out to earn the high interest rate available (the pool will go down when it is borrowed and shorted, then go back up again if and when the new buyer makes it available for shorting). There is also leakage from people who buy and don't make their stock available for shorting. The professionals doing this are often big quasi-index funds and hedge funds who keep the juicy 15% interest rate for themselves and also Custodians (usually big banks) who lend the stock on behalf of the underlying client and pay that client 40-50% of the interest earned (Custodian keeps the rest for themselves). That way the Custodian earns extra fees and can cut the price of the actual Custody to win more business and then lend more stock. The investment manager often hates this but usually has no control over agreements between the Fund and the Custodian regarding stock lending.

MSB is only a small market cap, but lending fees would be around $A7.5m which is significant.

"Lending" is really a bit of a tax fiction - you are actually selling the stock with an agreement to get the same number of shares back in the future plus interest. For tax purposes it is regarded as lending (and you don't include taxable gains or losses in your tax return - that would kill it) but some people wonder for example if Fund X lends it, then Madam borrows it and sells it, can Fund Y buy the same parcel and then put it back in the lending pool and lend it so that aatisket can then borrow it and short sell it to Fund Z, who then puts it in the lending pool?

Well, yes, but if we let a parcel be 1m shares, we see that at the start Fund X bought 1m shares, and then made 1m shares available in the pool, which passed through the hands of Fund Y and now Fund Z owns them and Z makes 1m shares available. Fund X and Fund Y can no longer lend those shares, so the pool hasn't changed. However, Fund X and Fund Y can recall their lent shares (depending on their contractual agreement) - usually at any time - but often (for stocks paying a dividend) before the dividend goes ex to claim the franking credits - though the contract can take this into account. You would obviously also recall your stock in a takeover (creating a scramble for the shorts to cover at a crucial time), or also just before an AGM so you can vote your stock (because it is really sold with just an agreement to get it back - you don't actually still own it).

So, Fund X Has a contract to recall 1m shares, as does Fund Y, and at the most moment Fund Z owns them as they haven't been lent out yet! Madam owes 1m shares to Fund X and aatisket owes 1m shares to Fund Y.

Has the total number of shares in the company increased? No. The company just registers that Fund X originally owned 1m, that was sold to Fund Y and again sold to Fund Z - the company now only registers 1m shares in the name of Fund Z (or Fund z's Custodian).

There are 2 contractual agreements each to provide 1m shares back to Fund X and Fund Y by people who don't actually own any shares. This is what I call delayed or "frozen" buying it MUST happen at some point in the future whether the shorters like it or not. It may be many years in the future when a major pharma company makes a takeover bid, or it may be when the lending instos decide they want to receive a fully franked dividend, vote at an AGM, or sell their shares. The circumstances determine how much the share price will rise when the short is covered.

Where do the shares come from that Madam and aatisket must give back? Is there 8% of the company oversold that will create a crazy scramble in a takeover? No! The shares come from you and me (person A and person Ecoool2) - but we don't want to sell our shares at anything like current prices, so Madam and aatisket have to push the price higher until we are tempted to sell. I would guess that for most people that is well above the current share price.

Is it unfair that the same 1m shares have been sold twice and a third lot is now available in the pool to borrow and sell for a third time? Not in and of itself - remember that there have also been 3 purchases of 1m shares - by Fund X, then Fund Y, then Fund Z. For every short seller there has been a buyer.

My only concern is the way short sellers go about potentially manipulating the share price. It is easy to push the share price down dramatically in a thin stock which is burning cash with no dividend and earnings base of valuation. It is especially easy where there are big binary outcomes from medical trials and where most shareholders don't really understand the technology - and how could they when it is groundbreaking research and where most professionals don't have any idea on the underlying mechanisms of the cells and how traditional rules of thumb may be turned on their head (dosages etc). So the short sellers can be very effective in pushing down stocks like MSB, despite the fact that there are buyers on the other side. And that's why you see negative comments on HotCopper, particularly on days that the price is falling or when they can bend a story to make it look bad. Long holders do the same thing on the upside - but it is much harder to create a panic rise than a panic fall (see Behavioural Finance).

If you put out scary interpretations of news or rumors while you are shorting and if you constantly chip away with small amounts in the screen but load much larger amounts at higher prices, you'll probably scare buyers away. You can compound that by constantly selling down thru the buyers and making them feel like fools for paying too much, so they pull back. This doesn't work so well for big liquid stocks because it is harder when there are reliable dividend payments coming and a more solid basis for valuation. At present MSB is still "speculative" - you are buying it not for dividends or near term earnings, but for capital gains based on increasing valuations from trials and partnerships- and these can be very difficult to value (and hard to believe when the share price is plunging). You are really buying it because you hope the next guy will pay more - and if it is falling you get people panicking and saying "next it'll go down through X price" - that is fertile ground for the shorts.

Shorts argue they provide liquidity and price discovery. I believe this is garbage in thin and panicky stocks and markets - and even worse for stocks like MSB when they are in the development stage. I believe that the shorts can cause so much panic and destroy so much confidence that they cause share prices to fall way below intrinsic value. In extreme cases they can force banks to lose confidence and require companies to increase security, which often requires a dilutive rights issue. The shorts then cover their short at a big discount. They have played this game with MSB in the past, but it won't work now that the cash position is flush and the prospect of partnering deals is within the current financial year.

I believe there is a strong case to be made to ban shorts from stocks like MSB in the development stage- otherwise how will we ever become the "Clever Country " if we keep allowing these parasites to destroy value? Australia only has a small number of leading technology companies and local funds need many more than that to diversify the risk and justify investing in the development phase.

The government banned short selling of our banks during the GFC as they realized it was a panic. I believe they should do the same for biotechs in the development/cash burning stage or we will lose this technology offshore. Prices will still be "discovered" whether shorts are there or not. Liquidity could even be improved, as liquidity dries up when a stock is in free fall-so I don't think these arguments by the shorts are valid. Less volatile share prices mean a lower cost of capital and a distinct advantage for companies basing themselves where they can get the lowest cost of capital. The shorts push up volatility and the cost of capital and drive our best new developmental companies offshore.

At least many of the bigger short funds in our market have been underperforming lately. L1 long short has been a disaster and Regal has been underperforming for 3 years now (by over 15% vs index). That leads to the possibility of investors withdrawing funds, which in turn means they may have to wind down some of their positions.Have a look at the massive withdrawal of money from junk bond funds in the US last year. People chase high yield until it no longer delivers or their sense of risk changes. I have been told the L1 long short listing was such a bad experience that it has cruelled the market for similar listings. I'm not trying to pick on L1 or Regal, but they are two of the bigger local funds and very high visibility- so it is good to keep tabs on the likely future demand for their products.

Don't forget that MSB is the 22nd most shorted stock by market cap on Dec 27, and at 31 days to cover we could continue to see big rises in the share price with only small amounts of the net short being covered through this thin January period. NB only 643000 shares thru today with 20 minutes to go - that would double the number of days to cover to around 60 days (or 3 trading months) if it were to become the norm in January.

Less than 1.9m traded on Dec 28 and net shorts fell by 1.2m and that was enough to lift the price 15% from $1.04 to $1.20 in a day! There would have to be another 32 days like that to remove the short position!!

Even after the recent drop in shorts and rise in the share price, the gap between the two lines on the 3 year graph on Shortman is the biggest price discount period we have seen - even bigger than that which we saw in November 2016 (the last time shorts were peaking at a time the share price was at a low and just in front of good news - and the share price rose from $1.08 to $3.15 by the following April) - all similar conditions to now, except now the price is coming from a lower level, the shorts are much higher and the news is potentially better if we get a partner!

I hope that addresses a lot of the issues on shorts in MSB.