MSB trading, page-1077

Clarifying the share price movements overnight in US and explaining some aspects of the unusual price movements:

The US price does not “lead” or “lag” the Australian share price, UNLESS market moving info is released after trading closes in Australia.

Rather, the US price just reflects the movement in Australia the previous session plus the supply and demand conditions for stock that day in the US. If there is a large short position that a US trader wants to cover, then the US price will trade above the Aussie equivalent price that day (other things being equal). This could extend over a few days, and, in a rising market, may make it appear that the US price is leading. However, once the short position is covered, the US price will return to approximate the Aussie price. Vice versa if there is a big long position in the US which is being liquidated in a falling market – again, it will appear that the US price is leading the Aussie price down (although there is a smarter way for a US holder to do such selling – see next 2 paragraphs).

It is possible to buy US ADRs and bust them into 5 Australian shares and return them to sell in the Aussie market – so if the price moves too far away from the Aussie price, there is an arbitrage allowing smart traders to do this. This is limited by the much smaller volume of stock traded in the US market.

So, a smart US owner of stock seeking to liquidate a big position can use the Aussie market (with its much bigger trading volumes) to do this. You can do this with ADRs like Mesoblast, but you can’t do it as easily with dual listed companies like BHP and Rio etc because those shares aren’t completely fungible. This results in the float of ADRs in the US market falling and the number of shares available to trade in Australia rising – it doesn’t change the total issued capital of the company.

Of course, there is a small risk to the arbitrage trader that if they buy ADRs at a discount in the US market overnight, hoping to sell at a profit in Australia the next day and some bad news comes out between the US close and the Aussie open (or before enough volume trades in Australia to cover the position), then the price in Australia could fall below what they paid. There is also a small cost to hedge the currency risk in the period where MSB isn’t trading anywhere.

Arbitrageurs can also hold an open position for some weeks or months in both markets – adding and subtracting from each position as the relative prices move. They could’ve bought some cheap stock at the lows in the US last night and sell some of their Aussie stock at (hopefully) better prices at some stage today and therefore keep their position relatively constant while booking a few profits. This doesn’t always work of course and isn’t strict arbitrage of buying and selling at the same time in different markets – but traders do it anyway – and sometimes they get overextended or go over their risk limits in taking what may appear to be a small risk – then if the price in Australia starts to fall the next day they have to aggressively sell and magnify the price moves.

Why go through what appears a silly exercise in converting ADRs into shares to trade them elsewhere – aren’t they all just the same company? Apart from the extra volume in the Aussie market making it easier to get set, there are limits fund managers must obey in their investment management agreements or mandates.

The main reason Mesoblast originally listed in ADR form in the US is that some US funds can only hold US shares – and the listing of ADRs meets that requirement. They were asking the company to list ADRs in the US so they could buy. I guess MSB also hoped that the US market had a deeper knowledge of biotech and more US funds buying would push the US price higher and lead the Aussie price higher. This second hope hasn’t resulted in any long-term benefit, though you can’t rule it out in the future – although they would probably end up buying in both markets and you would only realise it was happening well after the event when substantial shareholder notices start turning up (if they go over 5%) or in the MSB annual report when you may see new holders in the Top 20 (although they’d probably be hidden in nominee companies).

A frictional element of the share price between Australia and the US is that most funds have to limit their holdings to one market or another (although this doesn’t apply to international funds, which, however, often have their own restrictions on absolute geographical limits). Thus, Aussie share fund managers generally can’t own US ADRs in their funds – even though they are in every other respect exactly the same as owning MSB shares; and many US fund managers can’t hold Aussie listed stock.

This does mean that the prices jerk around a bit between the two markets, with smarties in the middle able to make some profit if they are quick and disciplined.

So, I really don’t read much into the US market price overnight as it invariably corrects over time to the Aussie price when the short term supply/demand imbalance is ironed out (although this can often take several trading days). Remember, a price-sensitive announcement will move whichever market is open at the time (or is the next one to open if both are closed) - but the effect will usually be exaggerated if it is the US market first affected as the stock is much more illiquid there. The Aussie price is the real price as it is the biggest liquid market.

So, does the price fall today tell us a big US holder started selling in the US last night and is continuing today in Australia? I doubt it – the big US holders have been rock solid and have been adding to positions over the medium term and it is unlikely such strong holders would be selling in front of the trial results due in the next 2 months or while partnering deals have just started.

I think it is more likely that the excess demand over supply in the US in the past few days post the China announcement with Talys has settled down and the US price traded back to the Aussie equivalent overnight. That premium in the US in the past few days was probably giving some hope to weaker holders in Australia that the price here would go up to match the US price (though as I have shown, that US price is more a reflexion of short term supply/demand factors in the US adding to the base price set in Australia).

The fall in the Aussie market today is nothing more than a correction to the very strong rise in the price from $1.47 to $1.89 early on Tuesday. And it’s really not much of a fall after such a big rise. Markets do this. People take profits and prices find support before the next move. The weaker hands and short term traders are taking some profits – a Fibonacci retracement of 61.8% of that rise would be a 30c fall in the share price to $1.59. This could happen in the absence of any new fundamental news (though $1.60 should be pretty strong support and it could also stop at $1.65, filling the gap left from the price announcement and finding the support of the previous highs).

I don’t think it will get down that far however, as I expect strong fundamental news over the next two months to disturb the correction and propel the price up into the next trading range. However, as a long term holder a fall back into the $1.60’s wouldn’t disturb me, and I still expect it to top $2 in the near term after the current correction, and to eventually get up to and exceed valuations of the top US analysts which average around $5 per Aussie share.

The shorts still have a big position to cover and they have a lot more pressure on them than the longs. In the past month 1.2m short shares have been covered and the net short position has dropped from 5.32% to 5.02% yesterday’s figures reporting last Thursday’s position. This reduction in shorts is a minor move which gave a lot of support to the share price and was helped by the Chinese announcement. With more announcements to come, there’s a lot more short covering yet to go. Long-term holders who have done their own risk assessments of their positions shouldn’t have much to fear from the current correction – over $3 of potential upside and 30c of potential downside – that satisfies MY risk/return requirements!