Spotting sell signals

Undoubtedly, there is a valid moral criticism of aggressive shorting that profits from others’ distress, which is why it grabs headlines in exceptional times. More usually, however, hedging activities play a role in solidifying institutional portfolios against adverse price movements. While these strategies are not always suitable to be copied by private investors, the short positions of large asset managers form part of the narrative around individual stocks, so are worth monitoring.

What is a short position?

Simply put, investors sell shares they don’t own, or are ‘short’ of, because they think the price is going to drop in the future. In order to fulfil the trade, they will borrow the shares (eg, from a broker) to sell them at the current price. If they are right about the price falling, the investor can replace the borrowed stock having bought it more cheaply than they sold it for, thus making a profit. Of course, if the investor is wrong and the share price goes up, they will make a loss as they have to close their short position by buying shares for more than they sold them for.

For example, a fund manager doesn’t own shares in fictitious company ABC plc but thinks that they will fall, so sells 1,000,000 at 240p. The fund is ‘short’ of the shares, so will have to borrow them to fulfil the trade. If the fund manager is right and the price goes to say, 220p, then they will close the position by buying 1,000,000 shares at the lower price to pay back the borrowed stock. As the fund is buying at 20p a share less than they sold them for, it makes a profit of 1,000,000 x 20p = £200,000.

Total ‘short interest’ indicates the sentiment towards a stock in the market. It is the aggregate number of a company’s shares subject to live short trades (where the position has yet to be closed) relative to the total number of outstanding shares in the marketplace. In the example above, before the position was closed out, it would have represented a short interest of 0.1 per cent if ABC has 1bn shares outstanding. If there were a further two live short trades of the same size in the market, then the total short interest towards ABC would be 0.3 per cent. As a rule of thumb, stocks subject to an aggregate short interest of more than 2 per cent are noteworthy and rapidly changing short positions over this size will be relevant to buy-and-hold investors as well as short-term traders.

How can investors use short interest data?

Fund managers have been known to make wrong calls and, taken on its own, short interest data is not a signal to buy or sell shares. That said, it is always useful to be aware of seriously bearish sentiment towards a stock, as this could be a sign that the situation is worth monitoring before investing any of your own money.

Table 1: The most shorted FTSE 100 stocks

Source: Heckyl

Courtesy of market data firm Heckyl, Investors Chronicle has acquired details of the most shorted FTSE 100 companies as of 11 January 2016. The names that instantly leap out from table 1, are J Sainsbury (SBRY) and Admiral (ADM), with exceptional double-digit short interest of 16.79 per cent and 10.14 per cent, respectively.

So what does this tell us? Well, in the case of Sainsbury, there has been a high level of short interest for a few months, due to pessimism before Christmas about festive trading prospects. As it turned out, Sainsbury’s sales figures were the best of a bad bunch among UK grocers, but growing short interest since the new year reflects concerns as to whether the bid for Home Retail (HOME) will deliver value for shareholders. Interestingly, Home Retail was heavily shorted itself before the news broke of Sainsbury’s bid, raising the possibility of a ‘short squeeze’ (see page 24 for more) on the sellers if an improved offer is accepted.

In the past, merger and acquisition activity has provided arbitrage opportunities for hedge funds and a common strategy was to buy shares in the target company and sell the shares of the bidder. Merger arbitrage is less popular nowadays, after several funds got burnt in high-profile deals and it is therefore probably not a major factor behind the short interest in this instance.

Sainsbury is an Investors Chronicle Tip of the Year, based on its cheap valuation and sound strategy in the face of competition from discounters. All things considered, the main reason to steer clear of the shares would be if investors were uncomfortable with aspects of the still-possible takeover or any strains it could place on the company’s overall financial position, rather than the current short interest. While the uncertainty surrounding Home Retail places a big question mark against the overall investment case, arguments exist for Sainsbury as a contrarian play.

Admiral is a slightly different proposition. A thorough overview of the non-life insurance sector will be included in Investors Chronicle’s annual FTSE 350 round-up (in next week’s issue, out on 29 January), but operating profits face a squeeze from both sides (cheaper petrol means more cars on the roads – hence rising claims; competition is also ensuring downward pressure on premiums). With sentiment weighed down by the uncertainty of a change in chief executive, the level of short interest is another indicator that this is a stock to avoid for now.

Glancing over the other large companies subject to significant short interest, uncertainty over management is one common theme. For example, Marks and Spencer (MKS), which is subject to short interest of 3.39 per cent, is facing change at the top after Marc Bolland stepped down as chief executive. In the case of former Financial Times (and IC) owner Pearson (PSON), there seems to be a concern about mismanagement, as the market is indicating that the breakneck programme of reorganisation embarked on by chief executive John Fallon is not delivering many signs of efficacy for investors.

The vulnerability of companies to macro themes also drives short interest. A worrying debt bubble, China’s falling demand for raw materials and the US and European baby boomers’ change in consumption patterns as they retire (shifting from goods made in developing countries to services provided domestically) makes it likely that emerging economies will face further headwinds. With its investment exposure to these markets, the short interest in Aberdeen Asset Management (ADN) looks well founded.

Volatility in commodity prices has led to short interest in mining companies such as Glencore (GLEN) and Anglo American (AAL). Perhaps surprisingly, given the oil price is hovering around and has dipped below the $30 per barrel mark, there is minimal short interest (below 0.5 per cent) towards energy giants BP (BP.) and Shell (RDSB), implying that markets feel a dire macro situation is priced in.

This is not to say the same is true for the entire industry; our short interest data is for the FTSE 100 and it is a fair assumption that negative sentiment towards oil and gas companies is stronger further down the market capitalisation scale.

Pay attention to the rate at which short interest grows

As well as the sum of short interest towards a stock, it is worthwhile keeping tabs on the rate that sell positions are increasing. Table 2 shows which stocks have attracted the fastest build-up in short interest over the past quarter. Evidently there is still growing negativity towards the aforementioned mining stocks: Glencore (+64 per cent) and Anglo American (+nearly 69 per cent) are both subject to notably more short interest than they were three months ago.

As an aside, while a position of less than 2 per cent is not considered significant on its own, a large relative shift is another starting point for further research. Take Bunzl (BNZL), the supply services group, which has seen short interest in its shares grow by 148 per cent, largely on account of activity by BlackRock. This was possibly precipitated by a downgrade note from Goldman Sachs, citing the unfavourable risk/reward offered by the stock at current valuation levels.

Table 2: The FTSE 100 stocks subject to the fasted increase in short interest

Source: Heckyl

Beware the squeeze

It is never sensible to blindly follow the positions of asset management firms; the obvious pitfall being that they are capable of being wrong. The phenomena of ‘short squeeze’ is where sellers are wrongfooted by better-than-anticipated news or the market pulling the share price, of what was ostensibly an overvalued company, higher. When prices move against them, many funds will rush to buy shares and cover their short positions, pushing the price further upward and as buying pressure is ratcheted up (especially if there is positive turnaround or takeover news to boot), more short positions are ‘squeezed out’. Although shorts are often closed at a significant loss, this is still preferable to runaway positions that haemorrhage ever more money.

The highly speculative strategy of ‘short-squeezing’ involves buying companies, where funds’ short positions look in danger of being squeezed out. These types of trades should only be attempted by investors with a high risk tolerance using money they can afford to lose. Unlike short-selling itself, however, potential losses can be limited to what was paid for the shares (unless you are trading on margin when losses can be considerably higher).

For profit-seekers hoping to give fund managers a bloody nose the trick is in spotting short positions where there is a lack of liquidity. Potential squeezers pay close attention to a metric called the short interest ratio, which divides the total number of shares subject to short interest by the average daily trading volume. Taking Ashtead (AHT) as an example, the short interest of 6.88 per cent relates to 34,629,792 shares.

The average daily trading volume is around 1.76m shares, so the short interest ratio is approximately 20:1 or, in other words, it would take 20 days to close out all of the short positions based on average volumes. This ratio should set off alarm bells for anybody thinking about shorting the stock as there is a substantial liquidity risk that could make the position a target for a short squeeze.

Sector sentiment and hedging strategies

The positions of fund managers in relation to overall sectors can be a useful way to gauge broader sentiment and guide allocation towards cyclical or defensive shares. For example, short interest towards the mining sector has increased by more than 40 per cent in the past three months, reinforcing this as an area to avoid. Of course, the significance of short interest must be considered in the context of each sector’s weighting (in terms of number of companies and according to market capitalisation). Smaller sectors, for example, are likely to be weighed down by the sentiment on just a couple of the largest companies. It is also plausible that the relatively high short interest towards finance could be because the sector is so significant – its size and liquidity reduces the risk of a short squeeze for the sellers, so it is likely to be the subject of more positions at any given time, especially as investors will often have preferences between companies.

Table 3: FTSE 100 short positions by sector

More generally, if there is an increase in negativity across the board, it could be a signal to pare back exposure to UK equities and move more of your portfolio into less risky assets such as cash and government bonds. For sophisticated investors, there are a number of different instruments that can be used to a hedge a portfolio. Futures and forward contracts, contracts for difference (CFDs), covered warrants and short-leveraged exchange-traded funds (ETFs) all have their pros and cons, but an important universal principle is to ensure that the size of the hedging position corresponds, as closely as possible, to the value and volatility of the portfolio being hedged.

It is most simple to hedge using a vehicle linked to an index and the size of the short position will need to reflect that the composition of the portfolio will very seldom match this index exactly. Therefore, it is necessary to consider the portfolio’s beta (ie, its volatility relative to the benchmark index), which in practice is not a simple task. Not all investors have perfectly diversified holdings, so they are in any case subject to unsystematic risk, which cannot be hedged. That said, the addition of sensible short positions can help to mitigate the impact of bear markets.

About Heckyl: Heckyl is a real-time financial news and data analytics company, which synthesises millions of sources to discover patterns and trading opportunities pertaining to more than 40,000 listed equities, FX, commodities and macroeconomic events. Visit www.heckyl.com for more information.