Short selling

This May, Ocado investors finally had cause for cheer. Another group of stock watchers, however, was not so happy. Since its IPO in 2010, a series of financial setbacks combined with continued analyst scepticism about the robustness of its business model had made the online retailer a favoured target of a dangerous financial animal: the short seller.

So much so that last October, a whopping 18.01% of Ocado’s shares were out on loan (a good proxy for shorting) compared with 9.89% in 2011, according to financial information services group Markit.

But that was then. When Ocado announced its deal on 17 May to provide Morrisons with an online delivery service, its share price rocketed and as The Grocer went to press stood at 288.6p - 43% above its pre-deal price. The number of shares on loan, conversely, has plummeted to just below 5%, with short sellers shutting unprofitable positions as the retailer’s share price has risen.

Put simply, there’s less schadenfreude for the short sellers to indulge in. Even so, with 2.6% of shares of the FTSE 100 retailers generally out on loan - double the FTSE average - retail remains a key play and Ocado one of the most heavily shorted stocks. Morrisons and Sainsbury’s have also made appearances in the top 10 most shorted retail stocks, with Marks & Spencer hovering just outside.

So what makes grocery so appealing to the short sellers, how does the practice work and is their cooling on Ocado a sign of things to come - or is interest in grocery retail set to remain as strong as ever?

“A lot of people are betting Tesco will recover and Sainsbury’s and Morrisons will therefore suffer”

Short selling - or borrowing shares or bonds to sell in the hope of rebuying them later at a lower price - isn’t a new phenomenon. Indeed, some historians trace its roots back to the 1600s. However, it only really entered the public consciousness during the financial crisis, with many financial experts placing the blame for the collapse in bank stocks firmly at its door.

The modus operandi of the short sellers - typically asset managers and hedge funds such as Lansdowne and Blackrock - is breathtakingly simple. They borrow securities from big investors including pension and mutual funds, paying a fee to a brokerage sitting on large holdings of shares available for loan (for such long-term investors, there is little risk involved in lending out their shares, so there is no shortage of supply).

They then sell the shares on the stock exchange. If the price goes down, they can buy the same number of shares back for a lower price, returning them to the owners and pocketing the difference. However, if the shares rise in value, then the short seller must buy them back at a higher price and lose money - as many did when Ocado’s shares recovered following the Morrisons deal.

Share price fluctuations

As witnessed by the Ocado example, shorting can cause sharp fluctuations in share price, which is why the EU wants to ban the practice, although it’s found little support for this stance in the UK where the high-stakes but highly lucrative practice continues to boom. Indeed, this June, the government called on the European Court of Justice to overturn powers allowing a Paris-based regulator to ban short-selling as part of a campaign to rein in growing EU powers over financial regulation.

Given the negative headlines short selling can generate thanks to its ability to turn normal fluctuations in share prices into wild rollercoaster rides, it’s no surprise that the groups behind this type of activity are wary of talking to the press. “We don’t like talking about short selling,” says David Waller, spokesman for MAN Group, a hedge fund that undertakes a small amount of short selling. “There’s a lot of sensitivity about being seen to drive down share prices.”

There’s little doubt that the crashing share prices caused by giant funds have pressured management at some retailers into making changes. However, there is also little doubt that these changes would have needed to happen anyway. “It [short selling] didn’t make one jot of difference to [Ocado’s] management,” contends Exane equity analyst Andrew Gwynn.

He argues that investors are beginning to treat Ocado as a technology rather than a retail play, and that they are actually quite upbeat about retail’s - or at least online retail’s - potential.

This may explain why Lansdowne Partners was one of the few hedge funds to have bucked the trend with Ocado and taken a long position on the company in December, increasing its stake to £28m - equivalent to 5.7% of the company. Desptite Ocado’s share price bounce back, many other funds have maintained short positions including: Blackrock Investment Management, GMT Capital Corp and Kynikos Associates.

But now the company is marketing itself to retailers across the world as a one-stop solution to their online retail needs - a tempting proposition in countries such as Germany, where online grocery is little developed -suddenly the Ocado model looks much more enticing to long-term investors once more (and rather less to short sellers).

That’s more than can be said for rival grocery retailers who are wedded to the traditional bricks and mortar model. Squeezed middle-class incomes, along with a flat economy, mean there is little confidence in some mid-market retailers and plenty to play for as far as the short sellers are concerned.

The mid-market squeeze

Nowhere more is this more evident than with the two big grocery chains being shorted at the moment - Sainsbury’s and Morrisons. Morrisons, in particular, is trailing badly in an online market dominated by Tesco and both could be exposed if Tesco’s renewed focus on the UK pays dividends.

“In the big three food retailers, you see a lot of ‘pairs trading’ by fund managers, where they take a big bet on one of the big companies and offset it by shorting another, on the view that one will gain at the expense of the other,” explains retail analyst Nick Bubb. “In this case a lot of people are betting that Tesco will recover in the UK and that the other two will therefore suffer.”

Tellingly, the only significant fund short on Tesco is the only one that was long on Ocado - namely Lansdowne, which is also short on Sainsbury’s (along with Pelham Long Short Master Fund) and on Morrisons (along with Lone Pine Capital and Meditor Capital Management). So it’s betting against all the bricks and mortar players - unlike the others.

The general favouring of Tesco is not, however, the only reason Sainsbury’s and Morrisons are being targeted so aggressively by short sellers. According to one City analyst, in Sainsbury’s case a lot of investors fear that the retailer will eventually be squeezed in market share terms by the growth of the discounters and Waitrose, and they have been unimpressed by its “lack-lustre” profits performance.

“Sainsbury’s hasn’t been very good at translating good sales growth into good profit growth, albeit Justin King talks a good story,” says the analyst.

As for Morrisons, the retailer faces a number of challenges, says Bubb. “There is a genuine concern about the pressure on profits from the weak momentum in the core business and the high price being paid to catch up in the online and convenience store growth battle,” he says. “Some investors think that Dalton Philips has pushed the core business too far upmarket and that he won’t survive another profit warning.”

The outlook for M&S is similarly gloomy. “In M&S’s case, some investors are betting that profits will remain under pressure because of the competition in clothing (notwithstanding the hype about the new autumn ranges), that the CEO will go and that vague bid rumours will come to nothing.”

At the moment these are just fears - there’s no need for King, Philips and Bolland to panic just yet. Although the percentage of their shares out on loan be above the FTSE average, it’s far from the 18% Ocado boss Tim Steiner faced at the height of the online retailer’s short selling scare (see chart below).

Short selling graph

Where there is arguably cause for panic - and a strong likelihood share prices will continue to fall - is among the non-food retailers in sectors hard hit by the recession, or by online competition. More than 10% of shares in WH Smith and Home Retail Group (owners of Argos and Homebase) are out on loan as short sellers gamble on a collapse in share price.

While the City may have lingering concerns about some grocery retailers, none are in such dire straits. That’s not to say short sellers aren’t continuing to circle the sector. Far from it. But their interest is not as intense as it once was.

Moreover, despite the UK’s best efforts, the Paris-based European Securities and Markets Authority was given the power last year to ban short selling after the practice was blamed for driving up national borrowing costs and threatening financial stability.

In short, there remains plenty of opposition to short selling and this, coupled with the first green shoots of recovery in retail, is likely to make life harder for the short sellers… in the short term at least.

Most shorted FTSE retailers (% of shares)

WH Smith plc

Home Retail Group

Carpetright plc

Dixons Retail plc

Ocado Group

WM Morrison

Darty plc

Greggs plc

Mothercare plc

Sainsbury plc

Next plc

Halfords Group plc

Marks & Spencer

Source: Markit

Targeted: retailers at the mercy of the short sellers

Take a look at the most heavily shorted retailers, or more precisely a list of the number of shares out on loan (used by Markit as a proxy for short selling) and two things immediately leap out.

Firstly, investor jitters over the sector have eased recently, with far fewer shares out on loan (usually as a result of announcements by the individual companies).

And secondly, different companies are being targeted by different hedge funds. There is no obvious cabal of ‘aggressive hedgies’ creating a run on these shares.

The reasons behind the short sellers’ interest in individual stocks are normally clear enough. WH Smith, the most heavily shorted stock, with over 16% of its shares out on loan, competes with Amazon for book sales - one of the sectors that has migrated most heavily online.

The second most heavily shorted stock is Home Retail, owner of Argos and Homebase.

Short selling interest has waned since Argos in particular started to post better results recently on the back of booming PC tablet sales, but it remains high with more than 11% of stock out on loan.

And its share price remains weak as analysts fret over falling margins, a reflection of its increasing reliance on cheaper tablet sales.

The most heavily shorted retail stocks reflect growing concerns about the threat from online operators, and fears that falling middle incomes could hurt shopping levels. These fears do appear to be easing and do not reflect a general belief that retail in trouble.

“Total retail sales grew as fast last year as in 2007, a boom year before the crisis struck,” says one equity analyst.

And Markit’s figures suggest, short sellers are getting out of retail at the moment.

The number of shares in the hands of short sellers has fallen sharply recently for companies such as Home Retail and Carpetright, where improving short-term results make a short-term crash in the share price less likely.

That said, some individual hedge funds have taken an aggressive position over certain retailers. Fest NV continues to hold a sizeable 2.9% stake in WH Smith, for example (albeit down from 3.9% in late January) and has also been short selling Dixons, according to the Financial Conduct Authority.

Funds including Blackrock and Germany’s Bau have also shorted 1%-2% of Home Retail, although again Bau has halved its stake over recent months.

And a plethora of hedge funds continue to short Ocado, although several (including Blackrock and Kynikos, which at one point was shorting more than 5% of Ocado’s stock) have slashed their shorting activity in the online retailer over recent months, off the back of the Morrisons tie-up.