Short selling is a practice by which market participants borrow stock in a certain company and sell it on the market. These short sellers then hope to buy back the stock (at a lower price) and return it to the lenders (to whom they also pay a fee for the privilege of borrowing the stock). Short sellers run into trouble when the share price of a company spikes, because they have to "cover the short" in order to limit their liability to stock lenders. When a stock is particularly heavily shorted, short sellers can send the stock price up very quickly, if they all rush to cover the short on the release of positive news. The table below depicts the 10 most shorted stocks on the ASX.
A high level of short interest often signals that the market is very pessimistic about the prospects of a stock. Sometimes, this is the perfect time to buy. For example, I'd consider an investment in Metcash Limited (ASX:MTS) (at current prices) because the distribution company is trading on a trailing dividend yield of a whopping 7.7%, fully franked. I simply don't believe that dividends will decline strongly over the coming years, although the company will likely experience sluggish growth at best.
Personally, I'm disinclined to invest in either News Corp (ASX: NWS) or Fairfax Media Limited (ASX: FXJ), because newspaper circulation is consistently falling. The companies undoubtedly own valuable brands, but they're finding it increasingly difficult to profit from them. I think the short sellers will make good money on these stocks, but I don't short sell myself because the profits are limited and the losses are unlimited. Stock prices can't fall below zero, but there is no cap on how much they can increase.
Cabcharge Australia Limited (ASX: CAB) is sold short because of the risk regulatory changes will reduce revenues, which they almost certainly will. I don't generally invest in turnarounds, but I wouldn't be surprised if the company eventually recovers.
UGL Limited (ASX: UGL), Bradken Limited (ASX: BKN) and Monadelphous Group Limited (ASX: MND) are sold short because their revenues are somewhat reliant on mining. The end of the mining boom, and the consequential reduction in capital expenditure will likely hurt these companies' margins and the volume of work they receive. Nickel miner, Western Areas Ltd (ASX: WSA), is probably shorted due to expectations the price of nickel will remain low. The shares are up almost 10% today, which may be a result of short covering and accumulation by Wellington Management.
It doesn't surprise me that Myer Holdings Ltd (ASX: MYR) shares are sold short. The company recently experienced a website crash on Boxing Day, perhaps the most important day of the retail calendar. Managing Director Bernie Brookes says that the impact of the week-long outage will be less than $1 million in sales, but I believe the mishap has far-reaching implications.
To my mind, the most attractive of these heavily shorted stocks is Cochlear Limited (ASX: COH). Cochlear has 57 million shares on issue, with approximately 15% of the company sold short. That means short sellers have borrowed approximately 8.55 million shares. Eventually they will have to buy back these shares and return them to their lenders. Last week, the highest number of Cochlear shares traded on the ASX on a single day was 150,000. The average daily volume over the last 30 days has been just over 200,000. Therefore, based on the average daily volume of the last month, short sellers would take over 40 trading days to accumulate enough shares to cover their obligations.
Foolish takeaway
I recently featured Cochlear on my list of 7 ways to play the ageing population, and I believe that it is currently a very attractive investment, especially at under $56 per share. Short sellers are probably counting on increased competition putting the company's margins under pressure, but they are playing a dangerous game if the lower Australian dollar continues to boost the company's profits.
