What is a short, bear raid and activist short?
Shorters or Short-sellers borrow shares, sell them, buy them back at a lower price and profit from the difference.
Most shorting is done by hedge funds and institutional investors to protect their investments against falling stock prices or to benefit from a share they believe is too expensive. A so-called “bear raid”.
Shorters have long been demonised for spreading panics and even causing or exacerbating crashes. Some hedge funds have been criticised that they spread false rumours to cause a major share price correction, whilst selling their holding, called “short and distort.” Supporters of their practices point to “pump and dump” schemes, which aim to hype up a share price, whilst selling shares during the artificial rise and the fact that they help identify dubious companies or management teams by exposing liars or dodgy accounts. They claim they help counter market or company-specific euphoria, where companies are blatantly overvalued. High profile companies say they help prevent suspect companies from exploiting investors as regulators like the FCC or FCA or auditors are spineless or too slow to spot fraud. I guess recent failures like Carillion and Paterisseir Valerie support that view.
The Big Short: Inside the Doomsday Machine
The 2015 film, the Big short, is a biographical comedy-drama film, based on the 2010 book The Big Short: Inside the Doomsday Machine by Michael Lewis, showing how the financial crisis of 2007–2008 was triggered by the United States housing bubble. The film stars Christian Bale, Steve Carell, Ryan Gosling and Brad Pitt.
The film is famous for the unconventional techniques it employs to explain financial instruments. Among others, it features cameo appearances by actress Margot Robbie, chef Anthony Bourdain, singer-songwriter Selena Gomez, and economist Richard Thaler, who explain concepts such as subprime mortgages and collateralised debt obligations. Several of the film's characters directly address the audience, most frequently Gosling's, who serves as the narrator. The film won the Academy Award for Best Adapted Screenplay in addition to nominations for Best Picture, Best Director, Best Supporting Actor (Bale), and Best Film Editing.
The film focuses on three short-sellers: Michael Burry, FrontPoint Partners and Jared Vennett and Brownfield Capital.
In 2005, eccentric hedge fund manager Michael Burry (Christian Bale) discovers that the United States housing market, based on high-risk subprime loans, is extremely unstable. Anticipating the market's collapse in the second quarter of 2007, as interest rates would rise from adjustable-rate mortgages, he proposes to create a credit default swap market, allowing him to bet against market-based mortgage-backed securities, for profit.
His long-term bet, exceeding $1 billion, is accepted by major investment and commercial banks, but as it requires paying substantial monthly premiums, it sparks his clients' vocal unhappiness, believing he is "wasting" capital. Many investors demand that he reverse and sell, but Burry refuses. Under pressure, he eventually restricts withdrawals, angering investors. Eventually, the market collapses and his fund's value increases by 489% with an overall profit of over $2.69 billion.
FrontPoint Partners and Jared Vennett
Deutsche Bank salesman Jared Vennett (based on Greg Lippmann, played by Ryan Gosling), the executive in charge of global asset-backed securities trading at Deutsche Bank, is one of the first to understand Burry's analysis, learning from one of the bankers who sold Burry an early credit default swap. Using his quant to verify that Burry is likely correct, he decides to enter the market, earning a fee on selling the swaps to firms who will profit when the underlying bonds fail. A misplaced phone call alerts FrontPoint hedge fund manager Mark Baum (based on Steve Eisman, played by Steve Carell), who is motivated to buy swaps from Vennett due to his low regard for banks' ethics and business models. Vennett explains that the packaging of subprime loans into collateralised debt obligations (CDOs) rated at AAA ratings will guarantee their eventual collapse.
Conducting a field investigation in South Florida, the FrontPoint team discovers that mortgage brokers are profiting by selling their mortgage deals to Wall Street banks, who pay higher margins for the riskier mortgages, creating the bubble, prompting them to buy swaps from Vennett. In early 2007, as these loans begin to default, CDO prices somehow rise and rating agencies refuse to downgrade the bond ratings. Baum discovers conflicts of interest and dishonesty amongst the credit rating agencies from an acquaintance at Standard & Poors. Baum's employees question Vennett's motives, yet he maintains his position and invites Baum and company to the American Securitisation Forum in Las Vegas. Interviewed by Baum, CDO manager Wing Chau, on behalf of an investment bank, describes how synthetic CDOs create chains of increasingly large bets on faulty loans – up to 20 times as much money as the loans themselves. A horrified Baum realises that the fraud will completely collapse the global economy. He purchases as much as possible, profiting at the banks' expense and waits until the last minute to sell. Baum's fund makes a profit of $1 billion, and he laments that the banks won't accept blame for the crisis and that people will scapegoat immigrants, teachers and the poor.
Investors Charlie Geller and Jamie Shipley accidentally discover a prospectus by Vennett, convincing them to invest in swaps, as it fits their strategy of buying cheap insurance with big potential payouts. Below the capital threshold for an ISDA Master Agreement required to enter into trades like Burry's and Baum's, they enlist the aid of retired securities trader Ben Rickert. When the bond values and CDOs rise despite defaults, Geller suspects the banks of committing fraud. The trio also visits the Forum, learning that the U.S. Securities and Exchange Commission has no regulations to monitor mortgage-backed security activity. They successfully make even more profit than other hedge funds by shorting the higher-rated AA mortgage securities, as they were considered highly stable and carried a much higher payout ratio.
Geller and Shipley are initially ecstatic, but Rickert is disgusted, citing the impending collapse and its effects; when unemployment goes up 1%, 40,000 people will die. Furthermore, they realize the banks and the rating agency are maintaining the value of their CDOs in order to sell and short them before the inevitable crash. Horrified, they try to tip off the press and their families about the upcoming disaster and the rampant fraud but nobody believes them. As the market starts collapsing, Ben, on vacation in England, sells their swaps. Ultimately, they make a profit of $80 million, with their faith in the system broken.
Jared Vennett makes $47 million in commissions selling off the swaps. Mark Baum becomes more gracious from the financial fallout, and his staff continues to operate their fund. Charlie Geller and Jamie Shipley go their separate ways after unsuccessfully trying to sue the rating agencies, with Charlie moving to Charlotte to start a family, and Jamie still running the fund. Ben Rickert returns to his peaceful retirement. Michael Burry closes his fund after public backlash and multiple IRS audits, now only investing in water securities. The banks responsible for the crisis escape any consequences for their actions. It is noted that as of 2015, banks are selling CDOs again under a new label: "Bespoke Tranche Opportunity".
Muddy Water and Carson Block
Activists shorter find targets that they allege have either accounting irregularities or less than honest business practices. In August, San Fransisco-based hedge fund, Muddy Waters, run by Carson Block, accused the AIM-listed company, Burford Capital (BUR), of “egregiously misrepresenting” returns. MW has also successfully targeted litigation conglomerate, Quindell (now Watchstone Group), and failed Chinese Timber company, Sino-forest.
MW describes itself as “ a pioneer in on-the-ground, freely published investment research. Muddy Waters peels back the layers, often built up by seemingly respected but sycophantic law firms, auditors, and venal managements. We pride ourselves on assessing a company’s true worth, and being able to see through the opacity and hype that some managements create. Our research approach is to combine diverse talents, including forensic accountants, trained investigators, valuation experts and entrepreneurs, many of whom have hands-on experience running businesses in the U.S. and emerging markets.
Muddy Waters produces three types of research product: Business fraud, accounting fraud, and fundamental problems. Business fraud reports focus on issuers that have massively overstated their revenues. Accounting fraud reports cover real businesses that boost profits through fraud. Fundamental problem reports discuss opaque businesses that have serious fundamental problems that the market does not yet perceive.”
Muddy Waters said that Burford manipulated its return on invested capital (ROIC) and internal rate of return (IRR) on the investment by categorising Napo's case against Salix Pharma over its diarrhoea drug as a win with a significant return “when it should have been a loss”. Burford, in its original response on 8 August, said it had structured its financing agreement with Napo so that any funds recovered could come from not just Napo’s dispute with Salix but from other litigation. “As it transpired, a litigation matter other than the Salix matter resolved first, and resulted in entitlement for Burford,” the company said in its response, which it said explained the figure shown in its 2013 financial reports. It did not clarify which “other” matter by name, however. Muddy Waters said this was a “depraved” effort to “conceal adverse results”. Thanking a bulletin board commenter called ‘Drunken Sailor’, the hedge fund pointed to a separate arbitration dispute between Napo and another of its licensees that “it was clear well before the end of 2013 that the outcome was completely adverse for Napo”. Without the win fee related to Napo, it is suggested that Burford would have reported a 2013 loss rather than the profit that it did. The hedge fund said Burford “stops just short of actually lying” but was looking to “deceive investors about its Napo returns and its overall investing prowess”. Burford shares lost two-thirds of their value after the initial report, have recovered to some extent in recent months as the company says it will improve governance, transparency and plans to list on a full US exchange to aid this aim. The shares are currently 924p, versus a 52 week high of 2045p and 1500p before the shorting attack.
Companies like MW use social media as a platform for their analyses. In 2017, shorts began campaigns against 186 companies globally, versus 130 in 2013, according to Activist Insight Ltd.
The U.S. targeted short selling during the Great Depression and joined the likes of the U.K., Germany and Japan in limiting short selling or banning it during the 2008 financial crisis China blamed “malicious” short-selling for a major stock market correction in 2015, placing limits on short trading and even arresting traders and jailing them.
Examples of where shorters got it wrong
Short-sellers targeted online grocer, Ocado, in 2011-2012. The shorters were betting on an imminent crisis at the company but they overlooked that it had rich and loyal shareholders, some of whom were always likely to be willing to dip into their back pockets to avert the possibility of a breach of borrowing covenants. The shorts cited a dodgy business model, poor financials, since the company had never made a profit, despite years of trading. The company had floated at 180p in 2010.
Ocado was founded in April 2000 by Jonathan Faiman, Jason Gissing and Tim Steiner, former merchant bankers with Goldman Sachs. Ocado was launched in January 2000 as a concept and started trading as a business in partnership with Waitrose in January 2002.
In November 2008, the John Lewis Partnership transferred its shareholding of 29% into its staff pension fund and in May 2010 the John Lewis Partnership entered into a 10-year branding and supply agreement with the company. In February 2011, the John Lewis pension fund sold off its entire Ocado shareholding - whoops!
In November 2012, Ocado raised £35.8m by placing 55.9m shares at 64p, a premium to the prevailing share price The new cash allowed them to go ahead with a £100m borrowing facility with Barclays, HSBC and Lloyds to be extended by 18 months. The shares rose by 25% on the news, shorters, who were betting the company was finished, were burned.
In the subsequent years, Ocado shares have gone into overdrive, following deals with French supermarket group, Casino, Canada's second-largest supermarket chain Sobeys, owned by Empire Company and Kroger, the US retail company, to build up to 20 Customer Fulfillment Centres (CFCs) using Ocado's automated technologies On 27 February 2019, Ocado and Marks and Spencer announced a Joint Venture, whereby M&S acquired a 50% share in Ocado's UK retail business.
Last week Ocado shares closed at 1189p, compared with that placing of 64p in 2012. A rise of nearly 19 fold in those 7 years.
Current shorting case study - Metro Bank (MTRO)
The UK based, high street, Challenger bank, Metro Bank (MTRO) is one of the heaviest shorted shares in the UK right now. At over 10 percent, it is in the realm of recent shorting successes such as Thomas Cook (which recently went bust). So is MTRO going the same way as Thomas Cook.
Based on the $300 million bond offer and Q3 results (October 2019), I would say not. The shares are currently at 226p, with high volatility. After a botched loan impairment in early 2019 and problems with a bond issue in the summer, the shares have collapsed from £40 in 2018. They traded as high as 285p last week on rumours of a takeover from Virgin Money (VMUK) and Lloyds Bank (LLOY) was reported in the Evening Standard. The shares fell 8% to 226p on Friday, following reports from broker Goodbody, that a takeover won’t happen until the FCA loan investigation is over (which could take until 2021).
Surprisingly, Marshall Wace increased it’s short slightly to 2.04%, but Crispin Odey and his Odey Asset Management have a short position of 3.65%. Why are they still shorting the shares at this share price? Coincidentally Goodbody is a 5-minute walk from Odey in Mayfair, London. Do they know something that private investors don’t e.g. fraud, accounting issues, a massive fine by the FCA? Or are these shorters falling into an Ocado trap? From even the 52 week high of 2346p, the shares are looking awfully cheap. MTRO now has a tier 1 capital ratio of over 16%. See details of Q3 results: https://contrarianinvestor.net/posts/2019/10/23/metro-bank-mtro-q3-2019-results-beats-analyst-expectations-despite-gloom-about-the-bank?rq=metro%20q3
1. Continued strong customer growth (an increase of 109k accounts to 1.9m)
2. Contrary to the most vocal bears, net deposits actually grew by just over a half a billion pounds and indeed, ex the wobble in Sep ref the MREL which caused a £213m outflow would have been one of the strongest on record. Keyline ref the Sep outflow is “…but we are returning to business as usual”. Not sure where the bears go with this one now…
3. The “loan to deposit” ratio improved to 105% and continues to trend towards 100%.
4. Non-performing loans were a nominal 0.2% – less than many other banks.
5. Shareholders equity remains at £1.7bn – approx £10 per share of book value with tangible book approaching £8.
6. Cost growth moderation going forward.
7. Tier (1) capital ratio (a key measure of capital strength) is now 16.8% – again at the top end of its peer group and reflecting balance sheet robustness. This is another key line – “As a result, the Bank’s Liquidity Coverage Ratio was higher than the 163% reported in Q2.”
In early October, a £300 million bond issue offering a coupon of 9.5% and later upped the amount to £350 million after receiving an enthusiastic reception at that interest rate. At that point, the shares were trading at 240p, before the Q3 results on October 25th.
MTRO bonds continue to recover.
With MTRO not going bust (unless I’ve missed something truly awful), with takeover rumours, and even that ex-Chairman Vernon Hill may take the bank private, I cannot see how the shorts have got it right at this point. They were right by the summer of 2019 with big profits, but now?? It is more Ocado than Sino-forest at this point. Contrarian cannot see a catastrophe around the corner after the reassurance from the Q3 results unless the auditors and financial governance are totally abysmal and fraudulent..
There are rumours of more news this weekend. Let’s see.