Where To Find The Stocks To Buy And Sell

The share market is one of the few places where you can profit when things go wrong as well as when things go right.  Savvy investors with solid reason to believe a company is in trouble, or soon will be, can bet on the downward movement by selling the stock short.

You know the procedure.  You “borrow” shares of XYZ from your broker and “sell” them at $10 per share.  You don’t actually “buy” the stock until it has dropped to a level that gives you the return you hoped for.  The big risk is that the loss of capital is potentially infinite.  If you took a long position in XYZ at the same $10 per share and held it through bankruptcy, your loss would be limited to $10 per share.  If you short the stock at $10 and it goes to $20 or $30 you could fall into the same trap many long investors do.  You hang on until the share price takes you back to a profitable trade.  Only with short selling, your losses can keep mounting as long as the stock continues to rise.

Playing the game of watching your short position rise can lead to opportunities for long investors – the short squeeze, or short covering rally.  When a heavily shorted stock begins to rise the shorts are faced with the decision of whether to buy back at a loss or hold.  When enough evidence pops up that the stock price is likely to continue rising, short sellers panic a bit and rush to buy back, inflating the stock price.

Conventional wisdom is that short sellers are often the smartest people in the room and usually get it right.  But sometimes they don’t.  If you are among the bold minority actively looking for investing opportunities hidden within these dismal market conditions, the ASIC (Australian Securities and Investment Commission) short list is a place to look.

They report short sales movements on a daily basis.  We have compiled a table of stocks with more than 10% short interest as of 06/21/2012.  The short interest percent represents the number of short shares as a percentage of total shares outstanding.  In our initial table we have withheld the short percentage but included the trailing twelve month Return on Equity for each share.  Since ROE is a favored metric of value investors – with an ROE above 15% representing a stock for further research – one might expect at least some of the shorted shares to have low ROEs.  Using the trailing twelve month as opposed to the ROE for a fiscal year accounts for variations in the preceding twelve months not represented in a figure that could date back to July of 2011, depending on the company’s reporting period.  TTM uses recent half year and interim results reported in its calculation.  Here is the table:

As you can see, only two of these stocks had a negative ROE and three were well above the 15% benchmark used by value investors.  Since short shelling is about betting on the future, positive numbers like these and the high dividend yields don’t matter to many short sellers.  But in some instances, the ROE can provide a clue that maybe the shorts have it wrong.  Now here is the table showing the short interest as of the 06/21/2012 report and the report for the first trading day of 2012 – 01/02/2012:

Every stock in the table has increased its short interest in 2012 with some showing substantial increases.  JBH (JB Hi Fi) has led the ASX in short interest for about a year, losing 50% in share price year over year.  The following share price performance chart matches the six month period of shorting activity in our table.  Here is the chart:

It certainly would appear the shorts got it right on this one.  The entire retail sector is heavily shorted with five of the ten stocks making frequent appearances in the top ten including David Jones, Myers, Harvey Norman, and Billabong.  We chose to include JBH not merely because it has led the list for so long, but because of the variance between the opinion of the short sellers and the opinion of analysts from Australia’s major brokerage firms and the high ROE.

JBH rose to prominence with its lowest price business model and that same model is responsible for its fall.  Competitors have been nipping away at JBH with even lower prices, forcing JBH to respond leading to lower margins and lower profit.  In their half-year reporting back in December of 2011 the company showed a 5.67% increase in revenue but a 9.36% decrease in net profit after tax.  Despite the unrelenting pressure from short sellers, lower margins, and lowered guidance, not a single one of Australia’s top brokers are screaming “SELL, SELL, SELL.”

Indeed, a recent Thompson/First Call analyst opinion summary showed 2 BUYS, 10 HOLDS, 2 UNDERPERFORMS, and only 2 SELLS.  Based on lowered guidance, major analysts have cut target prices but Deutsche Bank is of the opinion that further downside risk after a 50% decline is limited.  RBS Australia maintained its BUY rating as of 30 April 2012, although with a lower target price of $12.30.  They foresee a halt to what some have called irrational pricing in the sector.

While investors with high risk tolerance might find JBH worth a look, the second share in the table, Fairfax Media, is a definite STAY AWAY.  The shorts are spot on with this one as media stocks everywhere are struggling and now we have the spectacle of a food fight on the company board.  Mining heiress and the largest shareholder Gina Rinehart is making a lot of noise.  Three top executives from the editorial staff recently resigned.  Better to stay on the sidelines and watch the action.

The jury is still out on travel operator FLT (Flight Centre).  With Australians beginning to reduce credit purchases FLT’s retail segment has suffered along with other traditional retailers.  They have an online booking operation but price cutting has led to lower margins.  Their balance sheet is strong with modest gearing of about 22% and total debt of around $170M but they have $800M cash on hand.  Despite the woes of the retail environment and pricing pressures in the travel business, analysts see little reason to short this stock.  According to Thompson/First Call, 13 analysts have BUY or STRONG BUY ratings on FLT with 2 HOLDS, 1 UNDERPERFORM and no SELL ratings.  If you had jumped on the short wagon in January of 2012 at around $16.75 a share, you would have had a bit of a bumpy ride as it is now trading around $19.  Here is their six month chart:

The Cochlear (COH) story is well known to most retail investors.  A veritable juggernaut in the medical stgice space with dominant market share in hearing implants, the company announced a recall of one of its flagship products back on 12 September 2011.  At the time no one knew for certain the extent of the recall and the potential for increasing failure rate and subsequent loss of market share and brand reputation.  Shorts bet on a worst case scenario and initially they appear to have been right.  Here is a one year price chart, showing the drop in price following the catalytic recall announcement:

From the chart we can see share price bottomed out around $45 per share and has been rising ever since.  This is probably due to the general belief was that Cochlear handled the recall well.  Now some analysts think that COH is losing market share to rival Advanced Bionics and the stgice failure rate is still in question.  This is one company where at least for the time being the shorts and the analysts agree.

Despite the recent rise in share price, shorts are not rushing to cover and in June of 2012 COH was downgraded by both Macquarie – from OUTPERFORM to NEUTRAL – and Deutsche Bank – from HOLD to SELL.  UBS and Citi also have SELL ratings on COH, citing continuing loss in market share and questions about stgice failure rate.  While COH might return to its glory days, there are enough questions to make retail investors like you and me look for other opportunities.

Our next stock, Iluka Resources (ILU) saw the greatest increase in short interest of any of the stocks in the table.  ILU is in the resources sector, focusing on mineral sands products of rutile, synthetic rutile, ilmenite and zircon.  These products have a wide variety of applications, all subject to global macroeconomic worries.  The company has announced a series of production and revenue downgrades and the shorts have been licking their chops and piling on.  Here is a six month share price performance chart for ILU:

Score another one for the shorts with ILU.  Shorting at around $15.50 at the beginning of the year led to a paper profit of around $4.50 per share as the stock is now around $11.00.  While major analysts have lowered their target prices, none have downgraded ILU to SELL.  Citi as of 21 June 2012 maintained its BUY rating and preferred stock status, citing earnings growth, cash flow generation, and dividend yield.  In addition, they highlighted the fact ILU is one of the most shorted shares on the ASX and cautioned investors to expect high volatility going forward with positive news possibly leading to a short covering rally and more negative news yielding more fodder for the shorts.

Lynas Corporation (LYC) is a resources stock focused on rare earth minerals.  They have the potential to be the world’s first new source of rare earth mineral supplies outside of China, but initial enthusiasm for the shares has waned as evidenced by a 2 year share price movement chart:

The trouble began in September 2011 following an announcement LYC would not pay a dividend for FY 2011, but that alone cannot account for the share price drop.  Despite its promise, LYC has yet to generate a dime in revenue and although their Mount Weld operation is on track, their efforts in Malaysia and Africa have been problematic.  LYC is a good example of a once “hot” stock growing “cold” as operational realities dampen investor enthusiasm.  Despite the increase in short interest since the start of a new trading year, major analyst recommendations in May and June 2012 are uniformly bullish.  LYC now has a temporary operating license for the Malaysia plant and this led UBS to upgrade the stock from NEUTRAL to BUY.  Macquarie, Deutsche Bank, JP Morgan, and RBS Australia cited the same issue as all maintained BUY, OVERWEIGHT, and OUTPERFORM ratings; although with lower price targets.

The shorts appear to be betting that the Malaysian license will not progress beyond temporary status to a full operating license and issues in the African project remain.  While there is promise here according to analysts, this is a high risk investment where the shorts may end up trumping analyst opinion.

The final stock in the table, Carsales.com (CRZ) is the most puzzling as evidenced by their six month price movement chart:

Despite a doubling of short interest between January and June 2012, the share price has continued to climb reaching new 52 week highs in late June.  Carsales.com is a provider of online automotive services to consumers and businesses and the leading provider in Australia.  They have a strong balance sheet with no debt and about $26M in cash on hand as of the most recent quarter (mrq).  Their trailing twelve month (ttm) profit margin is 37.82% with an operating margin of 53% and a return on equity of 59%.

Despite these performance measures, the analyst community as a whole is mixed on CRZ.  Thompson/First Call recent breakdown of overall analyst opinion shows 4 BUY or SRONG BUY, 8 HOLDS, and 2 UNDERPERFORMS.

Yet when you look at the actual share price performance, you have to wonder exactly what the shorts and some of the analysts are thinking. It could be simply a matter of the stock looking toppy.

Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au.

You should seek professional advice before making any investment decisions.