Drilling into the top 30 short list

Retail investors confident enough to pick their own stocks are constantly hunting for sources of new investment opportunities.  Value investors and bargain hunters monitor the 52-week low and daily top market fall lists.  Some ignore another potentially potent source – the Top 30 Short List.

Why?  It doesn’t take long for a virgin share market investor to stumble on financial articles warning retail investors to stay away from short selling.  This conveys the notion that short-sellers are the “smartest people in the room.”  

It comes as a surprise to those newcomers to learn that not everyone looking to make money in share market investing bets on stocks going up in price.  Short-sellers make the opposite bet, that the price of a given stock will go down.

The advice to stay away from shorting as an investment strategy appeals to common sense when one learns the potential risk in a short investment is infinite.  When a retail investor goes “long” on a $10 stock with a purchase of 100 shares, the ultimate risk in the investment is locked in at $1,000, should the company fail and go belly-up.

When short-sellers target a stock, they essentially “borrow” the shares with the transaction remaining open until the short buys back the shares to repay what was borrowed.  So shorting 100 shares of a stock trading at $10 leaves an open position of $1,000.  If the short-seller proves to be on the mark and the share price goes down, the 100 shares are bought at the lower price, with the difference going into the short sellers account as profit.  Buying back is called covering a position.  If the short-seller covers at $5.00 per share, the profit is $500.

The infinite risk here should be obvious.  If the stock goes the wrong way and explodes to the upside, the short seller is faced with the decision of how long to wait before covering.  At $15 per share the loss is $500, and on and on, theoretically to infinity.  Faced with that choice some short sellers feel “squeezed” and resort to panic buying, not selling.  Long investors panic by selling, which accelerates the decline in share price while shorts panic by buying which accelerate the rise in share price.

A classic short squeeze benefits long investors’ bold enough to bet the shorts got it wrong.  So, it would seem digging into the Top 30 Short List makes sense.

A starting point is to check analyst consensus growth forecasts, as found on financial websites like Yahoo Finance Australia, Reuters, and Morningstar Australia.  Surprisingly, 16 of the 30 from the current list have double-digit growth forecasts.  The following table lists those stocks, with short percentage and sector along with the two-year earnings growth forecast.  

At first glance one might question the sanity of those shorting the four ASX miners with triple digit earnings growth forecasts. However, two years can be a lifetime in share markets and all those miners are in either pre-production or early production stages; meaning cash is flowing out, or just beginning to flow in.  The shorts are betting things may not go as planned, with unexpected production delays or cost overruns and they could be right.

One thing seasoned investors look for in assessing the prospects of a sector is capital investment activity from the major players.  An article appearing on 21 June in the Australian Financial Review entitled There’s more to come in mining investment splurge paints a rosy picture on the future of mining expansion and construction.  An early June article in australianmining.com.au cites a PwC (PricewaterhouseCoopers) report showing profits posted by the top 40 mining companies around the world were up 126% in the past year.

The following table lists price history and balance sheet information for the four ASX miners with those staggering earnings growth forecasts.

Galaxy Resources (GXY) is a pure play lithium miner with assets here in Australia at the Mt Caitlin Project, along with the Sal de Vida Project in Argentina, and the James Bay Project in Canada.

The Mt Caitlin Project is up and running as of May of 2017, with 5-year offtake agreements now in place with “multiple customers”, according to the company.  The company reported revenues of $AUD126 million for FY 2017 with EBITDA (Earnings before Interest Taxes Depreciation and Amortisation) of AUD$60.3 million.

A recent Definitive Feasibility Study (DFS) for Sal de Vida showed positive potential for both lithium and potash and the Galaxy share price got a short-term boost on 29 May when the company announced the sale of some its exploration assets in the region to South Korean company Posco, raising $280 million.  Short interest declined following the announcement, but the share price is trending downward again.

James Bay is in the Feasibility Study phase.  With Mt Caitlin outperforming analyst expectations and the Sal de Vida Project showing substantial promise, Galaxy maintains an analyst consensus OUTPERFORM recommendation, with UBS being the latest firm to upgrade the stock.

Investors and analysts appear to be looking at demand potential for lithium required for batteries to power Electric Vehicles (EVs) and other uses while the short sellers may be focusing on the ups and downs of the price of lithium as well as oversupply conditions.  The percentage earnings increase for Galaxy is a bit deceiving as the big jump in EPS (Earnings per Share) expected in FY 2018 is expected to drop from 2018’s $0.442 to $0.154 in FY 2019.

Independence Group Limited (IGO) is a diversified miner with three projects in place.  The company’s flagship project is the nickel/copper Nova Mine in Western Australia.  Independence acquired 100% of the project from its 2015 takeover of former owner Sirius Resources.  The price of nickel has been rising since the takeover, due in part to the use of nickel in the production of lithium-ion batteries.

The company also has a 30% interest in the Tropicana Gold Mine with the Long Nickel Project acquired from BHP Billiton back in 2002 has been placed in care and maintenance status. Nova went operational in July of 2017 with funds now available to bring the project to full capacity.  Independence also has an exploration stage project at Jaguar in Western Australia and the Bentley copper/zinc/silver operation in production.

The company’s FY 2017 results were solid, with revenues increasing to $422 million from $417 million and profit swinging from a loss of $59 million to a profit of $17 million.  Earnings per share for FY 2017 came in at $0.036, forecasted to rise to $0.27 in FY 2018 and $0.467 in 2019.

The share price fell sharply in response to the falling price of nickel but has recovered as the nickel price began to rise.

Orocobre Limited (ORE) mines both lithium and boron in Argentina.  Lithium miners in Australia extract the mineral from rocks while in Argentina lithium is extracted from salt brine pools.  Weather is a major problem for lithium from brine production as conditions must be near perfect for the evaporation process to work.  During 2017, Orocobre downgraded production forecasts for lithium due to the weather, much to the glee of the short sellers.  

In 2016 the company traded some of its Argentinian exploration assets for a 35% share in Canada’s Advantage Lithium, another brine producer.  Since then the two companies began a joint venture operation in Argentina called the Cauchari Project.

The company’s flagship project is Salar de Olaroz, a lithium from brine operation in Argentina that went into operation in 2015 with room for expansion.  In addition to weather issues, short sellers are focusing on the potential of a coming oversupply in lithium as more and more miners enter that market in anticipation of the supposed boom times in li-ion batteries over the next decade.

Syrah Resources (SYR) has been the number one shorted stock on the ASX for months on end.  Graphite is a critical component in the production of li-ion batteries and that is Syrah’s exclusive focus.  Its long awaited Balama Graphite Project in Mozambique Africa went into production in November of 2017.

Balama was hailed as having the potential to become the world’s biggest producer of spherical graphite used in li-on batteries, with Credit Suisse slapping a $7.80 per share price target on Syrah back in February of 2017.

The share price was plagued by project delays and cost overruns with the unexpected departure of its managing director on 5 October of 2016, plunging the already falling share price into a tailspin from which it took a year to recover.

Some analysts are warning investors to wait for the short sellers to begin exiting, but they show no signs of releasing the stock as the company’s troubles continue.  An early June terrorist attack in Mozambique was followed by more unwelcome news in mid-month.  A technical production issue led to Syrah downgrading its production guidance for the first half of 2018 from 40,000 tonnes to between 32 and 34 thousand tonnes, although management remains confident it will still meet its full year guidance of 160,000 tonnes.  

Syrah’s self-description is that of a technology company as well as a miner.  Not content to simply mine graphite, the company has embarked on an ambitious project to produce battery anode material (BAM) from spherical graphite, acquiring a site in the US state of Louisiana for that purpose.  The company expects to begin production by the end of 2018.

Syrah reported an EPS loss of $0.058 in FY 2017 which is expected to improve slightly to a loss of $0.033 per share in FY 2018 before turning positive in FY 2019 with forecasted EPS of $0.284.

Analysts appear unfazed by the short interest in these stocks, as Galaxy, Orocobre, and Syrah all maintain consensus OUTPERFORM ratings with Independence at HOLD.

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