Shares digital

With the markets in free fall the short sellers are risking their shirts on which stock will drop next – for a big pay day of course. Is this a game that every investor should be getting in on? Carlo Svaluto gets the drop on the fall

City pundits are still undecided about what direction the markets will take in the near term. Are the bears going to take over the world’s trading floors or is the sell-off that started last summer over? Stocks bounced back at the start of last week and some commentators interpreted it as a sign that investors were growing more confident. Yet, the worst may not be over, and if global shares do keep going down on economic woes, investors should be geared up to profit from falling markets.

Stock picking skills are probably even more important during bear markets than they are in bull markets. Only a few, more experienced fund managers manage to beat falling indexes and this is evident now as the vast majority of equity funds are registering negative performances.

To secure a return amid falling markets, you basically have to spot the shares that are to rise while others fall. You can focus on avoiding the shares that are to fall soon, and bet on the likely winners. But as well as doing that, you can also choose to bolster your returns by short selling the shares that are to fall.

A brief history of the short

Short selling or ‘shorting’ is a well-known way of trading that has been used ever since share trading began, as traders engineered a way to profit from falling shares. It has never been easy for the private investor, but widely used by hedge funds and more active fund managers.

It is called ‘shorting’ because it basically involves selling a security that a trader does not own and has to borrow first. Therefore, while the short position is opened, a ‘short seller’ is short of the security towards the subject who lent him the security.

Traders have been short selling shares for decades, and shorting has always attracted criticism, perhaps due to its purely speculative nature. ‘Shorters’ were initially blamed for the Wall Street crash in 1929 and have been singled out even recently. After HBOS (HBOS) tumbled 18% on 19 March amid rumours that it was near collapse, market watchdog FSA (Financial Services Authority) jumped in to say that it would tighten up control to spot traders who spread bad rumours and go short on shares.

Still, shorting is a popular way of making money in the City and can be a very profitable when the markets go south, if you apply a careful risk management strategy. It needn’t only be for reckless hedge fund managers. Nowadays especially, you don’t even need a special relationship with a broker to do it, thanks to the booming spread betting and CFD markets. These instruments allow you to profit from falling share prices with minimum effort.

However, if you preferred to go the traditional way, here is how it works in bare bones. You think shares in company XYZ plc, which trade at £10, will plummet, for instance, because they are overvalued or because its sector has reached a peak in sales. You borrow 100 of them from a broker depositing a sum of money, called the ‘margin’, as collateral. Subsequently you go to the market and sell the shares straight away, securing £1,000. Two months later the shares have fallen to £8 and you want to close your position to bag your profit. To do that, you have to buy back the 100 shares at £800 and return them to the broker. This way, you have made £1000 – £800 = £200.

Obviously, you have to strip out dealing costs, which can be higher than for normal trades, and the margin you deposited. But instruments like spread betting and CFDs, which require depositing a margin too, are tailored for private investors to profit from falling prices easily, without having to borrow a security, sell it and give it back to the lender.

Keeping your shirt

The risks involved with short selling are different, in fact opposite, from those that come with normal trading. With normal trading you can only lose what you have invested, say if the share price falls 100%, but the extent of your gains is infinite. When short selling it is the other way around. You can only make 100% the amount you invested but if your trade turns against you, there’s no limit to the amount you can lose. The game is slightly different if you trade CFDs or spread bets, as you are not borrowing a security but rather agreeing to a contract.

We mentioned that most equity funds are posting negative returns at the moment, after the markets took a battering in the second half of 2007 and at the start of this year. One of the fund managers that beat the credit crunch and is still registering chunky returns is Mark Lyttleton, who manages the BlackRock UK Absolute Alpha Fund. As of 31 January, the fund returned 1.3% in a month, compared to the FTSE All-Share’s 8.7% fall in the same period, and in the six months to 31 January the fund returned an impressive 6.1%, compared to the All-Share's staggering 9.5% fall.

In managing the portfolio of the fund, which was launched almost three years ago and has returned 11.8% (annualised) since then, Lyttleton is using very active investment strategies, that involve a relatively large use of short selling. The manager’s short sells have gained him remarkable success during the last few months, as did his ‘pair’ trades. This is another popular trading strategy which involves shorting – if the movement of two stocks are correlated in that when one rises the other falls, traders will sell the outperforming stock and buy the underperforming one and profit from the spread between the two. The Absolute Alpha fund’s exposure to pair trades was a hefty 48.6% as of 31 January.

Interestingly, in terms of the fund’s composition, financials is the most widely represented sector in the fund at 4.4%, followed by oil & gas at 3.8% and resources at 2.2%. Among the ten largest holdings there is Aim-listed real estate firm Dolphin Capital Investors (DCI:AIM), pub operator Punch Taverns (PUB), media outfit United Business Media (UBM) and caterer Compass Group (CPG).

Hedging the risks

As with any investment strategy, there are no ready-made rules for short selling, but there are a few key points to remember. First, use a stop loss, as there is no limit to the amount money you can lose. Peter Klein, head of Saxo Bank of London, says that setting stop losses ‘allows them [investors] a degree of comfort, to walk away from the markets and be fully mobile, without the fear that their losses will be unlimited should the markets move against them in their absence.’

The size of the positions an investor takes should be measured to the higher risk profile of short selling. Richard Cunnigham, managing director at City Index Advisory, says that is sensible to ‘assume lower position risk than you might on longs’. Also, he adds that investors should steer clear of companies that are about to release scheduled results and dividends, as it is difficult to interpret how the market will react to both result stories, however positive or negative they look like.

How can investors spot stocks that are to fall then? The simple fact that a share is overvalued should not be a reason to short-sell it, according to Cunningham. He says: ‘Shares may remain overvalued for protracted periods of time, and market momentum can take them into much higher territory. Broker downgrades, depending on the broker, can materially assist a short position.’

Cunningham adds: ‘One of the greatest determinants tends to be the degree of existing long or short exposure in the share that you are shorting. For example, if many hedge funds and traders have been shorting a stock for a week the probability of a sudden “short covering price squeeze” are much higher.’

The ‘short covering price squeeze’ phenomenon shows how the popularity of short selling as an alternative investment strategy can sometimes have adverse effect on stocks. When a share is heavily shorted, meaning that a lot of the stock is on loan to investors, and its price has plummeted, investors can be looking to close their positions quickly and all at once to bag their profit. If this happens on a large scale, the obvious consequence of lots of people having to buy the shares to give them back to their lenders is that the price will go up, and investors’ profits will be wiped out. This happens rarely, however, just last week, when the market enjoyed a bit of a rally, some commentators saw it as a consequence of a herd of investors closing their short positions.

Hedge funds with aggressive strategies sometimes track down the amount of stock on loan for shorting, and try to buy large chunks to squeeze the price up; that in return will have the effect of ‘shorters’ closing their positions quickly and sending the price up further. These adverse effects of shorting should suggest a clear lesson: that it is not a good idea to short sell stocks that are already being heavily shorted, as it is not a good idea to buy companies that already lots of people are bullish on.

How can investors keep track of the most shorted stocks on the market? Data of stock that is on loan in the market, called ‘stock loan data’, is gathered by CREST (Central Securities Depository), the system used in the UK and Ireland to settle equity and guilts trades. Data of activity on CREST can be found at www.euroclear.co.uk. The website provides tables with the percentages show how much stock of every company is on loan to investors. This should be a fairly accurate indication of what shares investors are most bearish on, and it may be surprising to see that some companies have double-digit percentages of their stock on loan to investors. Does that mean that, for example, 30% of XYZ plc is owned by investors who are shorting the shares, thinking that shares in the company will take a battering? Unfortunately, not quite. A number of things should be taken into account when looking at ‘stock loan data’.

The stock loan conundrum

First, while it is compulsory to register every trade of equity and gilts in the system, when it comes to stock on loan, only certain loan transactions have to be registered depending on how the loans are transacted. Therefore, stock loan transactions registered on CREST are not necessarily all the stock loan trades that take place in the market. Also, stock loan activity registered on CREST can also be for other purposes than short selling, like dividend arbitrage or dual-listing reconciliation.

When the markets started falling last summer, did shorting suddenly become a more popular strategy? At Saxo Bank, the volume of money used for single-stock CFD trades jumped 39% to ?4.5 billion in January 2008 compared with January 2007. Klein says: ‘While we do not isolate monthly figures, we suspect that much of the trading volume increased once volatility returned to the market from June 2007 onwards.’ Saxo’s figures also show that the number of CFD clients at the bank increased over the same period.

Obviously these numbers do not tell us that CFD traders turned suddenly short on shares. They simply reflect the growing popularity of CFDs. According to Klein, FSA is estimating that CFD-related activity accounts for 30% of daily equity trading flow on the London Stock Exchange. But also, it is reasonable to expect that a lot of CFD trading is being used by investors to short indexes and hedge their portfolios. Hedging is another benefit of short selling: investors can buy the equivalent amount of CFDs to the shares that he or she owns, balancing the loss of falling shares with the gains from short positions on the same shares. As a private investor, it’s not as easy to short a share as it is to buy one, so shorting shares with CFDs is a very effective way to hedge one’s portfolio. Saxo, to make the game even easier, will accept investor’s stock that is already in their portfolios as collateral for the CFDs margin requirements.

Looking at Crest’s stock loan data over the past few months, the fact that since the start of 2008 ETF (exchange traded fund) iShares FTSE 250 (MIDD) has occupied the highest ranks shouldn’t surprise. ETF iShares tracks the FTSE 250 and lots of people have been shorting the index thinking that mid-caps would underperform large caps, as investors would switch to less risky assets. Interestingly, it has not been the case as iShares 250 is down about 2.3% since January, versus a 9% fall of the FTSE 100. This has to be put in perspective; as mentioned before the fact that lots of people have been shorting this fund may have had some positive effects on its performance.

The other companies that figure in Crest’s data have had a large percentage of stock on loan for months now. This shows why looking at stock loan data is not necessarily the way to decide which stocks you should short sell, as a lot of other people are doing it. In the list there are companies such as media retailer HMV (HMV), supermarket chain Sainsbury (SBRY), fashion retailer French Connection (FCCN), bank Alliance & Leicester (AL.), carpet retailer Carpetright (CPR), house builders Redrow (RDW) and Persimmon (PSN). It is true that short sellers of these stocks probably made good gains, as all of these stocks performed badly last year, but again this should be put in perspective of a market that fell as a whole. However, the list should at least give you a steer towards which sectors the market thinks are going to see large share price falls.

The retail sector is one, and a retailer should figure in your portfolio of shorts. The Bank of England still has its hands tied as it is not meeting inflation target, and it may not be able to cut interest rates to below 5%. At the same time, mortgages are becoming more expensive, even for people who have one already and this will directly affect consumer spending. The current year will hardly be remembered as a pleasant one by high street retailers. Financials are another obvious candidate, but the story is less straightforward here as it is not clear what state the banks’ balance sheets are in.

The sector is highly volatile so short sells should be chosen carefully and tight risk management policies should be applied. As for house builders, yes the UK needs houses but house buyers need mortgages to buy them and at the current house prices it is just too difficult to get one. Expect more falls in the sector, especially for those shares that have somewhat held up amid the turbulence at the start of the year.

Get shorting

Saxo Bank’s London director Klein believes there is at least another two sectors investors should look at for short selling opportunities: automotives, as weaker demand for luxury cars in the US and high EUR/USD exchange rate will hit manufacturers, and airliners, as high oil price will hit those targeting low fares, making cut cost carriers particularly vulnerable due to the segment they are targeting, which is more price sensitive than business related travel segment.

Last week (Wednesday 2 April) Seymour Pierce’s analyst Amit Thakar published a note saying ‘cut the shorts’, which argued that the markets’ recovery could be a sign short positions should be closed, even though it may be too early to develop long bias on the market. Whether this happens or not, there will always be shares that are due to fall, be it because of poor relationship between management and investors, change in valuations, or sector-specific problems. This is why we have put together a list of shares that you should seriously consider as shorting opportunities. Short selling needn’t be only for stock market mavericks, but for every investor who wishes to profit when shares head south.

Shorting: nuts and bolts

Short selling is a form of investment more suitable to risk hungry and experienced investors, as it needs borrowing shares from a lender, selling them and the buying them back at a lower price to return them to the lender and bag a profit. However, increasingly popular instruments like contracts for difference (CFDs) and spread bets make ‘shorting’ remarkably easier for investors. CFDs are simply contracts whereby a seller (a broking house) and a buyer (a trader or investor) exchange the difference in value of an asset at the end of the contract. If the difference is positive, the seller will pay it to the buyer; if the difference is negative the buyer will pay it to the seller. The contract requires depositing a margin too but it doesn’t require the trader to either own or borrow the underlying asset, making it equally easy to go long or short. A spread bet is fundamentally a bet that the price of a share will move upwards or downwards. Similarly to brokers, spread betting providers offer a bid-offer spread. For example, you can bet that the FTSE 100, quoted at 5999 bid and 6001 offer, will go up and put £10 pounds for every points it goes in your direction. At the end of the bet the profit is paid minus a daily charge (usually LIBOR + around 2%-3%) to keep the bet open and a deposit (usually between 5% and 10%) to cover the spread betting account. Both CFDs and spread betting have more favourable tax regimes than normal share trading. Neither needs stamp duty to be paid and on top of this profits from spread betting are exempt from capital gains tax. Among the largest spread betting and CFD providers there are IG Markets, City Index, Saxo Bank, Capital Spreads, CMC Markets to name a few. All of them offer internet platforms, demo accounts and seminars to get you started easily.

10 STOCKS TO SELL SHORT

DIMENSION DATA (DDT) 51p

Target Price (3 months) 46p

Relative Strength

1 month: -1.3%

3 months: -10.6%

The global IT Infrastructure group has began to look expensive, with an historic PE of 16.9 times at the current share price, and a 1.5% dividend yield. The last interim management statement in February said that the company was continuing to see growth but it has to be pointed out that a large chunk of the company’s revenue comes from South Africa. The country has been severely hit by power shortages and its economy is experiencing a slow down. Dimension Data will surely feel the blow. The shares have slumped at the start of January from around $64 to almost $46, a 28% fall, as news came that South Africa’s industrial activity would suffer. Subsequently the shares didn’t manage to regain what they had lost and this is probably a sign investors are waiting for further news that won’t necessarily be good.

FIDESSA (FDSA) 747p

Target Price (3 months) 670p

Relative Strength

1 month: -17.8%

3 months: -3.5%

The software provider posted positive results back in February, but the consensus of the City is that the good growth registered so far is going to slow its pace. The company provides consultancy services and its proportion of customers in the financial sector is large. Last year City firms had to adjust to the new MiFid regulations so the company saw buoyant demand, but if investment in software by financial firms slows down as a result of the credit crunch, Fidessa’s share price could suffer a de-rating. At the time of the results, number crunchers at Landsbanki recognised the good performance but downgraded the stock to hold, as they didn’t feel they had to touch up their earnings forecasts. This is clearly a bearish sign so Fidessa’s shares could go carry on going lower as the company updates the market on growth levels.

Pace Micro (PIC) 88.95p

Target Price (3 months) 75p

Relative Strength

1 month: -8.3%

3 months: -0.1%

Interims numbers at the end of February were positive for the set top boxes maker, as new CEO Neil Gaydon’s restructuring is having some effect. Profits came in higher on flat sales volumes. As part of the restructuring programme, Pace decided to acquire a business from Philips in a deal that was going to be worth £68 million. This was classified as a reverse takeover and the shares were suspended in December. Trading has resumed now, with the company announcing that the price of the deal was going to be lower at £63 million, but share price movements will be influenced by Pace’s feedback on the integration of the Philips business. This could prove more difficult than forecast, and after a brief jump in the shares, the price has already fallen from the levels seen before the suspension.

Moneysupermarket.com (MONY) 123.25p

Target Price (3 months) 110p

Relative Strength

1 month: -4.4%

3 months: 6.7%

The company posted positive results at the end of February, showing higher profitability for the year to the end of December. However, 2008 will be a completely different story for Moneysupermarket. Personal lending has started shrinking significantly, and the comparison site earns its fees from the companies it lists only if, after customers visit the website, they are then accepted for loans. This means that the first half of the year could see much lower revenues, as lending in the UK shrinks rapidly. Moneysupermarket also has a mortgage broking business which will obviously suffer. It has launched a website in Germany but operations aren’t going as planned. The shares halved in the second half of last year, bottoming at 100p and have risen since then, but as more news on the impact of falling personal lending comes, the share price will suffer.

BRITISH SKY BROADCASTNG (BSY) 577.5p

Target Price (3 months) 520p

Relative Strength

1 month: 0.5%

3 months: 4.6%

The broadcaster is hardly going to increase the number of customers if the UK economy recedes. However, when BSkyB posted a £36 million loss back in February, investors welcomed the fact that it was retaining customers. The management is confident that it can achieve all its targets but some issues are beyond its control. Analysts at Credit Suisse reckon the regulatory environment is a risk to the company’s performance. More importantly, competition is increasing and it will ultimately result in higher marketing spend, higher rights costs and a new investment cycle. Also, according to the investment bank, the shares trade at a premium to its peers in Europe, leaving little upside potential. From a technical perspective, some analysts also flagged up the price as one that is riding a downward trend.

CATTLES (CTT) 246.75p

Target Price (3 months) 220p

Relative Strength

1 month: 4.4%

3 months: -9.4%

The FTSE 250 company is a sub-prime lender, and while in the US defaulting borrowers are a common thing now, in the UK we may be only at the start. With rising house prices, relatively high base rates, and possibly contracting economic activity sub-prime borrowers will find it even harder to repay their debts. Rising unemployment is another issue that will make things more painful. Investors in Cattles speculated that with more restrictive lending criteria by high street bankers the company would increase its books but the question is whether it can do that profitably. Analysts at Numis predict that Cattles’ profits will be 15.4% lower next year and that the loan loss ratio will fall below the company’s indicated range of 8-9%. The shares have already fallen a lot but with no newsflow expect the price to fall further.

KINGFISHER (KGF) 135.7p

Target Price (3 months) 120p

Relative Strength

1 month: 3.1%

3 months: 9.1%

If not contracting, the UK economy is surely not expanding fast and wide. Customer spending is under pressure but the Bank of England can’t simply slash rates like its counterpart in the US as its inflation targets aren’t being met. The results released just weeks ago show Kingfisher is making less and less money, as profitability fell for the third consecutive year. Its dividend policy, which looked difficult to sustain, had to be re-shaped as the payout was halved at the final stage, and this means that at the current levels the yield attraction has vanished. Some of Kingfisher’s overseas operations, notably the Polish one, are doing OK, but in China, for example, the company will incur more charges and may decide to withdraw from Italy and Germany. Trading has been wobbly since January but the price is bound to fall further.

REDROW (RDW) 311.75p

Target Price (3 months) 275p

Relative Strength

1 month: 10.1%

3 months: 11.5%

The mid-sized house builders posted results that were below expectations at the end of February, which was bad news especially as analysts are making more conservative forecasts. The outlook is grim, anything can be said about house prices and the need for housing in UK but the fact is that mortgage lenders aren’t letting people borrow money. House prices have had massive run in recent years and are already falling as the supply of money is drying up. Profitability at Redrow was 35% down at the interim stage and the company is not getting enough land to develop quickly. It is highly geared at 40% which makes it harder to buy more land against new borrowings. Landsbanki expects profits to fall for the full year to £75 million from £120.5 million in 2007. Sell this share, but be careful as bid speculation may materialise.

BENFIELD (BFD) 245.75p

Target Price (3 months) 220p

Relative Strength

1 month: -9%

3 months: -3.2%

Full-year figures released last month by the insurer were highly disappointing, with broking revenue falling and all areas of the business suffering from weak dollar exchange rates. Lower income was registered at the company’s advisory business and the insurance broking business is experiencing softer markets. The group said that trading would continue to be difficult, and that this year’s trading result would be lower than in 2007. Numis said it would likely downgrade its 2008 PBT forecast from £51 million to a meagre £8 million. At the time of the results in mid March, investment bank ABN Amro said ‘Benfield appears to be building a reputation for under-delivery, a habit we believe it needs to kick fast’, and added that both the issue of the weak dollar and of subdued demand are outside Benfield’s control.

CAIRN ENERGY (CNE) £28.83

Target Price (3 months) £26.00

Relative Strength

1 month: 7%

3 months: 7.5%

The company is facing an uphill struggle to develop its fields in Rajasthan, Northern India as development costs spiral and the Indian government drags its heels on agreeing a deal on a key pipeline. Currently Cairn’s share of the costs is estimated to be around $1.8 billion although the company will provide an update around the middle of 2008. The stock has outperformed the market by nearly 100% in the last year and further complications in the development of Rajasthan could prompt a retreat in the share price. The key risk to this view is the prospect of a takeover, although management strongly refuted any suggestion of such a deal at the recent results announcement.