The collapse of public sector contractor Carillion (CLLN) earlier in January 2018 made millions in profit for a handful of investment sceptics.

Hedge funds and other sophisticated investors have coined it in through a process called short selling, or shorting. It involves placing a bet that a share price will fall. If the shares do decline in value, then the person shorting the stock makes a profit.

Hedge funds Bodenholm Capital and Coltrane Asset Management are believed to have made around £4m each from shorting Carillion’s stock since the company’s profit warning in July 2017, according to Reuters.

Carillion had been one of the UK’s most shorted stocks for the past 18 months thanks to what short sellers believed were under-appreciated financial weaknesses in the business.

Given the people shorting the stock have since been proved correct, does that mean all the other popular shorting targets are also going to see their share price fall? People shorting stocks aren’t always correct, but it is worth looking at the most popular targets to see why they may be on the list.

WHO IS ON THE LIST?

Struggling department store group Debenhams (DEB), grocery deliveries firm Ocado (OCDO) and doorstep lender Provident Financial (PFG) all remain high on the list of the UK’s most shorted stocks, according to Short Tracker, the website run by Castellain Capital.

Debenhams has issued numerous profit warnings in recent years as its outdated department store model is left struggling amid a structural shift to shopping online.

Ocado bears suggest the stock doesn’t deserve a premium valuation given its slow progress in finding lots of international partners to help drive the business forward.

Many analysts believe doorstep lender Provident Financial may have to raise new cash in order to pay any potential mis-selling fines and penalties, given it is being probed by the Financial Conduct Authority, a regulator. The business is also struggling with its turnaround plans.

Other companies on the list of most shorted stocks include retailer Pets at Home (PETS) which has struggled from weak sales, margin pressure and rising costs. Carillion still shows on the list because its shares have yet to be delisted from the stock market, albeit they are currently suspended and worthless.

FOUL SMELL & BAD TASTE

Short selling has frequently courted controversy. The idea of profiting from the failure of a business when shareholders, lenders, and in Carillion’s case, probably taxpayers, lose out financially leaves many ordinary people and investors feeling queasy. You also have to think that Carillion’s collapse could mean thousands of jobs get axed.

Short selling is sometimes criticised by corporates who feel they are being picked upon unfairly by speculators hoping to benefit from declines in their share price, according to Simon McGarry, a senior equity analyst at Canaccord Genuity Wealth Management.

Some critics have called for the practice to be stamped out completely.

‘But if short selling wasn’t allowed, traders with negative views of certain stocks would only be able to avoid them,’ counters McGarry. ‘Short selling allows hedge funds and other sophisticated market participants to generate returns based on their negative views of a stock,’ he says.

Put it another way, the emergence of short sellers in a stock puts a shareholder’s positive view under scrutiny. That should be a catalyst to revisit the original assessment, an extra test that may be useful in portfolio quality control.

RISKY BUSINESS

Even if you accept the supporting arguments for short selling, there remain very good reasons for ordinary investors to stay away from shorting.

Chief among them is the high level of risk inherent in the practice. When an investor ‘goes long’, betting on the upside of a stock, your maximum possible loss is 100% of your capital invested. That can happen from time to time, as we have seen with Carillion, but it remains relatively rare for a company to go completely bankrupt.

With shorting, investors risk far more than the amount they invest, and in mathematical terms, losses on a shorting trade are potentially infinite. That’s because there is no theoretical cap on how high a share price can rise, so seeing a short trade go against you is open-ended.

Remember that the more a share price rises, the more money someone shorting the stock loses.

Given the risk, and the imbalance of research resources available to hedge funds versus the non-professionals, shorting is probably best avoided. (SF)

WHAT IS A SHORT SQUEEZE?

A short squeeze is a situation where a sudden spike upwards in a share price triggers a rush of buying activity among short sellers.

Short sellers must buy stock to close out their short positions and cut their losses, which provides further fuel for the rising share price.

In turn that can compel even more short sellers to cover their positions, escalating the rising share price tide.

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