Brian Gaynor: A2 Milk in the sights of short sellers

A2 Milk has been attacked by short sellers on the ASX. Photo / Supplied

COMMENT:

Short selling — the strategy of borrowing shares to sell them with the aim of buying them back at a lower price — has become an increasingly important sharemarket activity.

In recent weeks, the Financial Times reported short sellers have taken a US$7.8 billion (NZ$12.1b) bet against US retailers, while MarketWatch revealed that investors have taken huge short positions on North American cannabis stocks.

In this part of the world, a2 Milk has been attacked by short sellers on the ASX while Summerset and SkyCity Entertainment have had similar, albeit lesser, experiences.

Short sellers can have nerves of steel, as demonstrated by the experience of US-based RH, formerly known as Restoration Hardware.

Warren Buffett's Berkshire Hathaway recently purchased 1.2million RH shares, sending the latter's share price soaring to an all-time high but short sellers, who have 37 per cent of the total shares on issue available to borrow, continue to hold their bear positions.

These short shares are mainly borrowed from long-term institutional holders who charge a fee, often a substantial one, to lend stock to these high-risk investors.

The world's three largest companies by market value — Apple, Microsoft and Google — are not immune to short selling. Nasdaq data shows Apple has 46 million short interest shares at present, or 1.04 per cent of total shares on issue. This compares with 98.6 million short interest Apple shares in February.

Microsoft has 62.7 million short shares at present, representing 0.82 per cent of its shares on issue, the highest level so far this year, while Google (Alphabet) has 2.9 million short shares, or 0.43 per cent of shares on issue. Google's current short interest position is also a 2019 year high.

Meanwhile, the ASX is a hotbed of short selling activity, as demonstrated by daily figures supplied by the Australian Securities & Investments Commission (Asic).

Asic has the following disclaimer: "It is important to note that Asic's aggregated short position reports are reliant on the accuracy of reports we receive from individual short sellers. While we monitor compliance with short position reporting and provide additional guidance where necessary, we are unable to verify the accuracy of all individual reports submitted to Asic, nor to verify that all short sellers in our market (both Australia and overseas) are lodging reports".

Naked short selling is prohibited in Australia, that is the sale of shares that haven't been borrowed. According to Asic: investors "must, at the time of the sale have power to direct a transfer of the product".

The figures on the right-hand side of the accompanying table show the largest ASX short selling positions, as measured by the number of shares sold short as a percentage of the total shares on issue.

Seventeen ASX companies have short interest positions of 10 per cent or more; Syrah Resources, Galaxy Resources and GWA top the list.

The ASX is a hotbed of short selling activity. Photo / AP

Syrah Resources, with a market value of only A$151m, operates a graphite mine in Mozambique with the output to be used "in the lithium battery supply chain".

Galaxy Resources, which has a market value of A$401m, has lithium production facilities, hard rock mines and brine assets in Australia, Canada and Argentina. The company's objective is "to create a sustainable, large scale, global lithium chemical business".

The large short selling interests in Syrah Resources and Galaxy Resources are because of concerns regarding an oversupply of graphite and lithium materials used in batteries.

GWA, which has a market value of A$895m, is a Brisbane-based supplier of building fixtures and fittings for households and commercial businesses. It reported normalised profit after tax of A$51.8m for the June 2019 year, a figure in line with the previous three full-year periods.

Short sellers have attacked GWA because they believe its debt levels are too high and its dividend unsustainable.

The troubled four major Australian banks have the following short interest positions: ANZ, 0.72 per cent; Commonwealth Bank, 0.68 per cent; National Australia Bank, 0.81 per cent; and Westpac, 0.64 per cent.

The figures on the left-hand side of the table show the short interest positions of New Zealand companies listed on the ASX. The NZX used to disclose short sale positions for the 10 most actively shorted securities but this data was discontinued several years ago.

However, the NZX has supplied short sale trading figures to this column for Tuesday November 26, which show that just over 8 per cent of shares traded that day — a particularly busy day because of index rebalancing — were short sales. This figure should be treated with the caution, as should the Asic figures, because they are totally dependent on the accuracy of reports submitted to the NZX.

The main point to note is the large short position on a2 Milk, a company that wasn't on short sellers' radars until late 2015. Its short selling interest gradually increased through 2016, mainly because short sellers believed the stock was overvalued, and it finished 2016 with short interests of 4.66 per cent.

Shorts attacked the stock with vigour in early 2017 to reach a peak of 9.28 per cent in July 2017, just before a2 announced its results for the June 2017 year.

The result was a whopper and the short sellers closed out most of their positions over the following seven months, with short interests hitting a low 0.08 per cent in late March 2018. During this period a2 Milk's share price soared from A$4.49 to A$13.04 as the shorts covered their positions.

Since then, a2 Milk's short interest positions have increased steadily and reached 8.01 per cent on November 19, the day before the recent annual meeting.

The meeting was relatively positive and a2's share price has rallied strongly since then.

However, short sellers have not given up, with their interests increasing to 8.16 per cent according to the latest Asic data.

Short sellers now hold 58.7 million a2 shares. Photo / File

Short sellers now hold 58.7 million a2 shares compared with average trading volume of 5.9 million shares per day on the ASX this month plus another 0.9 million daily average on the NZX.

A2's short-term share price performance will be heavily dependent on whether shorts hold their positions or decide to buy back their borrowed stock.

ASX short sellers have a 3.41 per cent short interest in Summerset, the second largest bear position for a New Zealand company listed across the Tasman. This short position started at 6.1 million shares, or 2.70 per cent of the outstanding shares, in January this year and has risen to 7.7 million shares, or 3.41 per cent, this week.

Short sellers and brokers don't always get it right: in early April a prominent New Zealand broker recommended that clients sell Summerset shares and buy Gentrack. In the intervening period, Summerset's share price has risen 18.4 per cent while Gentrack's has fallen 20.0 per cent.

Finally, SkyCity's short-interests position has increased slightly since the end of 2018, from 2.32 per cent to 2.37 per cent.

Short selling is a totally legal, but high-risk, activity that has several potential pitfalls including:

• The cost of borrowing shares can be expensive.
• Short sellers are required to return shares to the owners, often at an inappropriate time for the borrower.
• Borrowers are required to pass on dividends to owners.
• Short sellers can be caught in a "short squeeze", where they are forced to buy back stock when a share price is rising rapidly.
• Short sellers usually suffer losses when a company is subject to a takeover offer or other corporate action.

In conclusion, short selling is not for the fainthearted, particularly as there is no clear evidence that ASX short sellers have been consistently successful over recent years.

- Brian Gaynor is a director of Milford Asset Management.