Brian Gaynor: Short selling not a sure one-way bet

Christian Bale plays Michael Burry shorting mortgage-backed securities in The Big Short. Photo / File

Short selling, which involves selling shares first with the aim of buying them back at a lower price, is a well-developed investment strategy.

The strategy is widely used by hedge funds, with Bloomberg data showing that between 3.5 and 4 per cent of US sharemarkets have been short over the past seven years.

This compares with a short interest high of 5.5 per cent in 2008, during the height of the GFC.

Bloomberg defines short interest as a percentage of the total fee float value of US sharemarkets.

But shorting is not confined to individual securities. Bloomberg data shows that between 0.5 and 2 per cent of the four largest US Exchange Traded Funds (ETFs) have short interest positions.

Short sellers borrow shares or units from long-term holders at a cost, sell these shares, then later buy them back and return them to lenders.

ETFs or passive funds can charge low fees, partly because they lend shares to short sellers for an annual fee of 1 to 2.5 per cent or more.

Active fund managers are much less likely to lend stock because they want full control of their holdings, including the ability to vote shares at company meetings.

Short selling is a well-developed strategy across the Tasman with the ASX and Australian Securities & Investment Commission (ASIC) supplying daily data on short positions.

ASIC data shows that the top ASX short positions at the end of March were Syrah Resources with 20.6 per cent of its shares subject to short interest, Domino Pizza 17.6 per cent, JB Hi-Fi 16.7 per cent, Galaxy Resources 14.5 per cent and Healthscope 13.9 per cent.

Forty-nine ASX companies had short interest of 5 per cent or more at the end of March.

The New Zealand companies with the largest ASX short interest position are Fletcher Building 2.9 per cent, SkyCity 2.6 per cent, Sky Network TV 1.3 per cent, Chorus 1.2 per cent, Spark 0.7 per cent, Xero 0.6 per cent and Trade Me 0.4 per cent.

Fletcher Building's short interest position declined from 3.2 to 2.9 per cent in March, while Chorus increased from 0.7 to 1.2 per cent and Xero from 0.2 to 0.6 per cent.

Shorting is legal in New Zealand but the NZX can't make up its mind what role it should play. Several years ago the stock exchange published a monthly short sale report and tried to convince fund managers to lend shares to short sellers.

The short sale report is no longer available although Smartshares, the NZX-owned passive fund manager, lends shares to short sellers up to 50 per cent of the value of Smartshares' securities at any one time.

Short selling is back in the headlines in Australia following the attack on Blue Sky Alternative Investments by Glaucus, the Californian hedge fund.

Glaucus is no stranger to the ASX.

On March 21, 2017 Glaucus released a report on TFS Corporation when the latter had a share price of A$1.41 and a market value of A$552m.

Short interest in the Indian sandalwood plantation company had increased from 8.9 per cent to 14.2 per cent over the previous six months.

Glaucus noted that TFS was "one of the last remaining publicly-listed agricultural Managed Investment Schemes (MIS), a dangerous Australian investment structure beset by bankruptcies, investor losses and fraud".

The report went on to state: "We believe that TFS will likely follow Timbercorp and Great Southern (two other MIS schemes) into ignominy and failure.

In our opinion, TFS's model resembles such collapsed agricultural MIS companies and their Ponzi-like structure.

TFS does not generate significant cash from sales of its sandalwood, which for the most part has yet to be harvested. Instead, TFS is reliant on raising capital to plant new vintages, operate its business, make payments on its ballooning debts and pay off earlier investors."

The 39-page Glaucus report concluded that its TFS share price valuation was zero.
The report was perfectly timed as the following evening TFS rebranded itself as Quintis at a lavish function in Melbourne.

The star attractions at this function were two Quintis ambassadors, Australian test cricketer Adam Gilchrist and Australian formula one driver Daniel Ricciardo.

TFS/Quintis responded that the Glaucus report was self-serving and biased as it was designed to drive the company's share price lower for the authors' financial gain.

The rebuttal was to no avail with the TFS/Quintis share price falling 2.4 per cent on March 21 and 7.4 per cent and 13.4 per cent on the following two days.

Quintis shares had plunged to just A29.5c by May 12 when they were suspended.

Receivers were appointed earlier this year and Glaucus was declared the clear winners.

On March 27, just one year after its TFS report, Glaucus released a 67-page study on Blue Sky Alternative Investments, a fund manager offering private equity, private real estate and hedge funds.

Blue Sky listed on the ASX in January 2012 after issuing shares at A$1 each, giving it a market value of just A$16 million.

Blue Sky started slowly but became a market darling last year when its share price surged from A$7 to A$14.54.

The share price had eased back to A$11.43 on the day Glaucus published its report, giving it a market value of A$885m on that fateful day.

Meanwhile, short interest in the company had gone from 1.8 per cent at the end of 2016 to 1.6 per cent at the end of 2017 but then jumped to 4.5 per cent two weeks ago.

The basic proposition of Glaucus' research is that "Blue Sky is significantly overstating its fee earning AUM (assets under management) by reporting the gross value of certain assets as AUM instead of the fair value of the capital invested.

Based on our analysis, we estimate that Blue Sky's real fee earning AUM is at most A$1.5b, 63 per cent less than Blue Sky's reported figure (A$3.9b)."

Glaucus went on to write: "We believe Blue Sky compensates for its overstated AUM by charging clients egregious management fees, which can reach up to 17 per cent of the capital invested in Blue Sky funds and are charged irrespective of the performance of the underlying investment. Because investors will soon wise up, we view Blue Sky's fee revenues as inherently unsustainable."

Blue Sky's share price tumbled 9 per cent on March 28 before it was suspended from trading.

Blue Sky released a response to Glaucus' paper before trading was reinstated on Wednesday.

It argued that Glaucus "does not identify any information which previously has not been disclosed and which the board believes a reasonable person would expect to have a material effect on the price or value of Blue Sky's securities". It claimed that Glaucus "may have manipulated the market" and had formally invited ASIC to investigate Glaucus.

Investors were not convinced and Blue Sky's share price fell a further 18.6 per cent on Wednesday, from A$10.40 to A$8.47.

On Thursday, Glaucus released another 14-page report rebutting Blue Sky's response.

It claimed that the ASX-listed company "has doubled down on obfuscating", "has fallen back on threats and recriminations" and its management team "cannot answer basic questions about its fee structure, AUM and historic performance".

Blue Sky's share price fell a further 33.6 per cent on Thursday, from A$8.47 to A$5.62. It was trading at A$5.79 yesterday afternoon.

The Glaucus reports on TFS and Blue Sky demonstrate that investors mainly sell short because they believe that a company's business model and earnings are unsustainable.

Most short sellers do not release reports to the public but their underlying strategy is also based on the belief that a company's performance will fall well short of market expectations.

But short selling is not a sure one-way bet.

William Ackman, the famed US shareholder activist at Pershing Square Capital Management, has suffered huge fund withdrawals after his failed short selling attack on Valeant Pharmaceuticals and Herbalife.

Short selling is a risky and expensive strategy, partly because of the cost of borrowing shares. It can lead to huge losses, as well as profits.

- Brian Gaynor is an executive director of Milford Asset Management.