A growing number of Australian share market investors appear to have had enough with the dramatic volatility seen in the markets since the GFC.  Research firm CoreData Australia tells us over one quarter of Australian investors (27%) are planning to move out of risk investments into cash.  These figures represent year end 2011 and surprisingly enough, they are below the previous record set in early 2009 when the Great Financial Crisis was beginning to take its deadly toll.  A full 65% of those surveyed were of the opinion the economy would slow in the next quarter.

The complete findings of the research paint an extremely bleak picture.  At the beginning of 2012, Australian investors have less confidence in the markets in the prolonged after shocks of the GFC than they did during the GFC itself.  For contrarian investors, the bleak picture represents investment opportunities.

As you know, the herd often heads off en masse in the wrong direction.  As bearish or bullish sentiment mounts, more and more investors of all stripes jump on the bandwagon propelling the trend.  In a bearish environment such as the CoreData survey findings suggests, as more and more investors sell and move into cash, the contrarian believes a point will come when the market has nowhere to go but up.  

But how does one determine the point?  Contrarian investing is not an exact science with fixed points of entry and exit to guarantee results.  However, there are technical indicators like the Relative Strength Index (RSI) and others that offer clues.  For most investors, the best clues are found in analyst and popular financial press coverage.  When the news of the day screams out one dangerous sign after another, the temptation to follow the crowd and sell is compelling.  Similarly, when the news follows a steady drumbeat of positive on top of positive, it is easy to get caught up and start buying to avoid missing out on those big gains.

Successful contrarian investing involves deeper analysis into the reasons for the flight out of, or into, a particular share or share market investing as a whole.  Contrarians look to a variety of sources to find investing opportunities, among them shares making new 52 week lows and shares with low Price to Earnings Ratios.

The two sources we shall consider here are the lists of the most shorted stocks on the ASX and recent analyst downgrades.  In theory, both sources represent views of share market participants with some expertise in evaluating companies.  Short-sellers profit handsomely by identifying weak companies either already in or about to enter, a downtrend.  Many assume due to the high risks involved in short-selling, these bearish investors take great care to evaluate the companies they short.  

Analysts are in the business of providing investment opinions and downgrades represent their view something has changed or soon will change that will affect share price performance.  Here then are five shares culled from recent downgrades and the ASX most shorted stock lists.

Company Code Mkt Cap Sector P/E 52 Wk Hi/Lo Share Price
JB HiFi JBH $1,201M Retailing 9.98 $20.5/$11.10 $12.15
Cochlear COH $3,558M Health 21.25 $85/$45.11 $62.52
CSG Ltd CSV $170M Software 6.08 $1.44/$.60 $.60
Energy Resources ERA $699M Energy $5.09/$1.14 $1.35
Gloucester Coal GCL $1,690M Energy 25.2 $13.01/$8.32 $8.33


The first two shares in the table are from the short list and the remaining three have been recently downgraded.  Depending on the rationale and the severity of the downgrade, markets generally react negatively.  When a share is dropped to a hold or sell rating or had its target price slashed substantially, the crowd typically begins heading for the exits.

The rebound from a downgrade, in our view, has less potential for a substantial return than does the rebound with short sales.  If a downgraded share proves the analyst wrong, the return of buyers can have a positive impact.  However, that impact often pales in comparison to the phenomenon feared by bearish investors world wide – the short squeeze.

As you know, when you short shares you are essentially borrowing the shares at the shorted price.  Your profit comes when you buy back the shares at a lower price and return them, pocketing the difference.  With short selling your risk is theoretically infinite.  If you buy a share for $5.00 your maximum risk is the $5 you paid.  If you short the same share at $5 you will be liable for buying back the shares no matter how high it goes.  Thus, when a share with a high short percentage begins to rise, the shorts get nervous and in the face of continued rise they begin to cover en masse, fueling intense buying known as a short squeeze.

Of the two shares from the short list, Cochlear has more potential for a short squeeze.  Cochlear’s fall came about as a result of a voluntary product recall.  At the time, the reasons for the product failure leading to the recall were unknown and market experts feared substantial erosion in Cochlear’s dominating market share leadership position.  Here is a one year price chart showing the immediate aftermath of the recall.

As of 07 February 2012 the company claims the causes are now known and there has been no evidence of loss of market share.  Despite this fact, analyst recommendations appearing on 08 February 2012 included Sell Ratings from Citi and UBS, Hold Ratings from RBS Australia and Deutsche Bank, an Underperform from BA-Merrill Lynch, with only Macquarie coming in with an Outperform Rating.  In short, it appears analysts remain unconvinced.  Good news going forward could alter the picture dramatically.  This company bears watching, especially in the percentage of shares sold short.  If the percentage begins to drop, it might be the signal the worst is over.

JBH has had the dubious distinction of sitting atop the ASX most shorted stock list for most of 2011 and so far in 2012 has maintained that position.  Here is their one year price chart.

Unlike Cochlear’s single event collapse, the decline in JBH began with the softening of Australian retail sales in early 2011, which led to increased discounting and lower margins.  JBH’s position as Australia’s premier electronics discounter hurt them as their margins were already low.  Going forward, JBH will continue to suffer, with EPS forecasts being cut as far out as 2014.  For longer term investors, however, it is hard to argue with the solid performance numbers over time from both JBH and COH.  Let’s have a look.

  Revenue – $M (2011-2010) NPAT – $M (2011-2010) Operating Margins (2011-2010) Return on Equity (2011-2010)
COH $738.4-$696.2 $180.1-$155.2 32%-31.7% 34.9%-35.4%
JBH $2,959-$2,731 $109.7-$118.7 7.5%-7.3% 88.2%-40.4%


As you can see, despite their headwinds, both companies performed well.  JBH showed a decline in profitability but actually increased in revenue and managed to hold the line on margins.  Cochlear’s numbers do not reflect the impact of the recall.  For their Half-Year reporting in February of 2012 they reported an 8% decline in revenue with the subsequent 20 million dollar loss their first loss since listing on the ASX.  

Of the three companies from the analyst downgrade source, the one of greatest interest to contrarians is IT services provider CSG Limited (CSV).  Few things send investors running for cover in the way abrupt management changes do.  On 31 January 2012 RBS Australia downgraded CSV from a Buy to a Sell following poor preliminary half-year results coupled with the resignation of the company’s managing director.  

The company’s problems stem in large part from capitalisation and other difficulties with new acquisitions, which should be worked through over time.  What’s more, the new managing director is an insider with significant experience.  First listed on the ASX in 2007, CSV’s five year share price performance suggests it is a share worth watching.  Here is the chart:

The remaining companies, ERA and GCL might also merit adding to a contrarian buy list.  Energy Resources of Australia is a uranium miner abandoned by the analyst community en masse due to both the fall from grace of nuclear energy and weather related issues.  Currently only 2 brokers have a Buy rating on the shares with 6 Hold ratings, 3 Underperforms, and 4 Sells.

Gloucester Coal is in merger negotiations with Chinese coal producers Yanzhou Coal Mining (Yanzhou) and Yancoal Australia (Yancoal).  While a positive development in the eyes of many, it does not remove the risk of weakening demand in China.  BA-Merrill Lynch removed its price targets and rating on the company since the as yet unrealised merger proposal has the company no longer trading on fundamentals.

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