Take a look at the following chart of Fortescue Metals Group Limited (ASX:FMG).
It's clear that Fortescue (FMG) has staged an incredible comeback. But is it too good to be true?
Is it time to short sell Fortescue Metals Group?
The latest short list compiled by ASIC, the financial services watchdog, reveals that approximately 3% of Fortescue shares are being held short. That is, approximately 3% of shares were being lent to investors seeking to profit from a share price fall.
In my opinion, at the most basic level, successful short sales require us to identify companies with a high share price that could be facing a structural headwind, and a catalyst for the decline.
Let's see how Fortescue matches up with those criteria:
- Rich valuation and structural headwinds: Just over a year ago, Fortescue shares were trading around $1.53. That means the company is now worth 333% more. A simple way to assess the change in the market's belief in the company is to look at the change in its price earnings ratio (P/E), which tells us how many multiples of profit (i.e. earnings) the market is willing to pay to buy a share. Based on 2016 earnings, Fortescue's P/E ratio has gone from 3.5 times to 16 times. Using forecast 2017 profit, EPS has grown to 7.8 times.
The second part of this checklist is structural headwinds. In a nutshell, in my opinion, the market is pricing Fortescue shares as though current iron ore prices will continue indefinitely. If you think this will happen, here's an introduction to the school of hard knocks on economics: All price taking industries eventually return to their marginal cost of production. That's finance-speak for: Iron ore prices will fall to the industry's cost of production given the level of demand. China fuelled the last 20-year resources boom — it used more cement in the three years to 2013 than America did in the entire 20th century. It's an imperfect comparison, of course, but you get the idea — it would take something almost unbelievable to keep demand where it is. Meanwhile, supply levels are increasing rapidly.
And if you think Donald Trump's 'massive infrastructure plan' will save iron ore consider this: He plans to spend $1 trillion over 10 years, that's equal to what China spent in nine months last year.
- Catalyst. This can include things such as accounting irregularities, management blunders and regulatory change. Fortescue's management are top quality, which poses a risk to investors looking to short sell the company. However, I think a fall in demand could spark a sharp retraction in iron ore prices and send Fortescue's share price lower. A successful shorter would like to know when this catalyst may occur but I reckon we could see cracks start to appear in the latter half of 2017.
Foolish Takeaway
Short selling is risky and not something I like to do. However, poking holes in an investment is a great way to assess the risks and take the other side of the debate.
In my honest opinion, I would not buy Fortescue Metals shares at this share price.
