"Invert, always invert." — Charlie Munger
Short sellers borrow shares in a company in order to sell them on market. Because they will have to buy back the shares in order to return them, short sellers are therefore betting that the share price will go down. Academic studies have shown that short sellers are good for the economy, and help spot fraud, but the key question for investors is whether they should avoid shorted companies, or bet against the shorts by buying shares.
Vocus Group Ltd (ASX: VOC) had about 16.3% of its shares sold short on the 22nd of May, 2017, with 101.5 million shares sold short. That's around 13 times the daily average volume of shares traded since the share price tumbled on high volume in early May. That suggests that if the short sellers get cold feet en masse, we could see a short squeeze, although we'd probably need some pretty good news for that to happen.
One likely reason short sellers are targeting Vocus is that the market is currently uncertain about how the NBN Co will impact companies like Vocus. On top of that, there is now talk of the government introducing a broadband tax of over $7 month. While that would impact all telcos, not just Vocus, the result would likely be that some customers consider if they can drop down to a cheaper plan. Also, TPG Telecom Ltd (ASX: TPM) is planning to introduce a mobile service, which will probably put downward pricing pressure on all types of internet, not just mobile.
However, the larger issues stem from the fact that Vocus has arguably overstretched on acquisitions. The acquisitions of M2 Telecommunications and NextGen have imperilled the balance sheet, which now has over $980 million in debt. Time and time again, we see that companies have no defence against short selling when they have heavy debt loads.
A comparison with another short selling target can help us consider how strong the short thesis against Vocus is. Whereas Domino's Pizza Enterprises (ASX: DMP) relies on convincing more franchisees to open stores, Vocus receives fairly sticky revenues from customers. Importantly Domino's is trading on about 40 times earnings, whereas Vocus is trading on about 12 times the forecast underlying earnings. That means that there is a lot more potential for Vocus to 're-rate' to a higher multiple, than there is for Domino's. On the flip side, Vocus is already pretty cheap, and ultimately the company could probably just raise more capital to get out of its debt hole. While that would mean dilution for shareholders, it would likely do some serious damage to the short thesis.
As a result, I think Domino's Pizza is a better short selling target than Vocus.
However, the fact that the former CEO of Vocus sold his shares and quit the company has me feeling cautious about the stock. I'll wait a while before I buy shares myself, if I do buy shares, because I don't like the high debt levels. Asides from the debt, I think the company is in better shape than many give it credit for.
Vocus might be one for the contrarians, but many investors prefer stocks with better earnings momentum. As long as earnings per share keeps growing, year after year, shareholders tend to make a pretty penny. While I do think that there is room for a contrarian play like Vocus, few would disagree that investors should be looking for future blue chips for capital gains.
There's nothing more satisfying than betting against short sellers, and winning, because they then have to buy back the shares at higher prices, sometimes causing a 'short squeeze'. But I personally take a cautious approach and only bet against the short sellers if I have good reason to believe they are wrong. Still, Vocus could be very interesting, once debt is under control…
