It’s scary watching how quickly stocks are savaged. Like a scene from the movie The Revenant, a grizzly bear mauls an unsuspecting company and comes back for a few rounds of bloodshed. Unlike the Leonardo DiCaprio character, not all companies survive the attack. 

Consider Harvey Norman Holdings this week. Negative press is thought to have sparked a short-selling frenzy in the retailer. Chairman Gerry Harvey complained that short sellers were spreading false information and urged the corporate regulator to act. 

Troubled law firm Slater & Gordon also had a near-death experience from piranha-like short selling last year. Slater complained that short sellers were feeding false information to the media, but the short squeeze was on the money given the firm’s offshore woes.

Proponents of short selling say it aids price discovery. Detractors say it fundamentally goes against the spirit of the sharemarket as a mechanism to raise capital. Either way, short selling is becoming more prevalent, particularly in newer-style small-cap funds and Listed Investment Companies with mandates that allow short selling.

Short selling involves investors selling a stock they do not own. Typically, their broker lends the stock to them from the firm’s stock inventory, another firm or a large client. The shares are sold, funds are credited to the investor and at some point, he or she must close the short by buying back the same number of shares (covering) and return them to the broker. 

If the price falls (as the short sellers expects), they buy the stock back at a lower price and pocket the difference.  If the price rises, the short sellers must buy back at a higher price and lose money. Some stocks rally when short sellers are forced to buy at higher prices.

Australian Securities & Investments Commission (ASIC) monthly data on short selling is worth following. Aconex, Myer Holdings, Nine Entertainment Co, Worleyparsons, Metcash and Domino’s Pizza Enterprises are among the market’s most shorted stocks.

Like other investors, short sellers sometimes get it wrong. Worleyparsons, for example, has almost doubled from its 52-week low – a performance that crushed recent short sellers (Worley was the market’s ninth most shorted stock, as a percentage of issued shares, in March 2017)

Still, when buying an out-of-favour stock it pays to understand the level of short selling in its shares and gauge whether short-selling positions have been rising or falling (by comparing ASIC short-selling data over a long period). 

Domino’s Pizza’s ranking as the market’s 12thmost shorted stock (as a percentage of short positions held to total issued capital) in March does not surprise. The fast-food chain’s soaring valuation attracted a chorus of commentators who complained the stock was overvalued (some had said the same thing for years and missed an almighty rally). 

Media revelations about some Domino franchisees underpaying staff damaged confidence in the company’s operating model and cash flow. The news came as mid- and small-cap growth stocks were dumped in the fourth quarter as investors rotated into blue chips.

For the first time in a long time, Domino’s faced a tsunami of negativity. The stock fell from a 52-week high of $80.69 to $54.76, shedding about $2.3 billion in the process.

Chart 1: Domino’s Pizza Enterprises

Source: The Bull 

Unlike most other companies in the sights of short sellers, Domino’s issued a record sales result and profit in its FY17 interim report and upgraded its full-year guidance. It is aiming for 32.5 per cent growth in underlying earnings (EBITDA) for the full year, after notching 33.6 per cent in the prior corresponding period. Same-store franchise profitability hit records.

Unlike other stocks higher on the short-sellers list, Domino’s does not have a troubled business model or poisoned industry position. It is more of a “disrupter” thanks to market-leading food-ordering delivery technology than a disrupted company. 

Domino’s European business looks like a key growth engine in the next five years as new stores are opened and acquired stores are converted to the Domino’s brand.  The company should grow market share in the fragmented European pizza segment. 

Strong earnings momentum in Australia and New Zealand is another positive.

As I have written for The Bull previously, Domino’s has a technology advantage over its main fast-food rivals in Australia. This provides latent pricing power: look at how Domino’s disrupted the local pizza industry when it launched $5 value pizzas. Some independent and gourmet providers could not compete with this step-change in pricing.

Seven of 11 broking firms that cover Domino’s have a buy recommendation and four have a hold, consensus analyst forecasts show. None have a sell. An average price target of $69.24 suggests Domino’s is materially undervalued at the current $54.76.

I’m not quite as bullish. Domino’s has much work ahead to restore market confidence and put the underpayment issue behind it through good franchisee governance. Plenty of short sellers hope the company’s fall from grace has further to run. The recovery will take time.

But selling in Domino’s could be nearing exhaustion. The most bearish broking target ($49) is within sight of the current price and chartists will be looking for the stock’s sideways consolidation over the past few weeks to continue, forming a base in the price.

Domino’s looked badly overvalued at $80. At $54, it near value territory, in part because of all the negative media and short-selling activity. Such a highly-valued stock is always prone to short-term volatility around news flow. 

That creates opportunities for long-term investors who can see through the noise and negativity and focus on a company that consistently delivers one of the market’s highest returns on equity, has an expanding global footprint and significant technology advantage. 

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Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without considering your objectives, financial situation or needs. Before acting on the information in this article you should consider its appropriateness, regarding your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at March 23, 2017.