Having seen significant falls in stocks such as Sirius Minerals, Marks & Spencer and Metro Bank over recent weeks, I find myself paying more attention to the activities of short sellers than ever before.
For those new to investing, these tend to be sophisticated investors that bet on the share price of a company falling. I say “bet” but that’s probably doing the majority a disservice. Usually, these trades are the result of intensive research.
There’s a very good reason for this. While a share price can’t go below zero, a short seller’s potential losses are technically infinite because a stock can always go higher in price. In other words, they need to be very confident in their position.
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Sinking back
FTSE 100 publishing giant Pearson (LSE: PSON) is one example of a stock that many in the market continue to be pessimistic on.
While the shares performed well in the last quarter of 2018, they’ve sunk back 16% over the first half of 2019 — almost the mirror opposite to how stocks in the UK have behaved.
That’s clearly aggravating for existing holders, including star funder manager Nick Train. The hugely popular Finsbury Growth and Income Trust remains invested in the £6.2bn-cap — a little problematic when you consider its commitment to running a fairly concentrated portfolio of only 22 stocks (as of April).
Train clearly continues to believe that Pearson will survive and thrive in time. Maybe it will. Despite a big reduction in debt over the last few years and signs of progress with its new strategy, the stock is still the ninth most shorted on the market.
A valuation of 14 times forecast earnings reflects fears over a proposed merger of McGraw-Hill Education and Cengage — a deal that would form the second-largest supplier of textbooks and higher education materials in the US — and the potential erosion of Pearson’s market share.
With general market sentiment still looking fragile as a result of ongoing political and economic concerns, I’m not surprised some view Pearson as an unnecessarily risky proposition, at least over the short term.
A very average 2.5% yield, although expected to be covered three times by profits, is also questionable compensation for holders while they await a sustained recovery.
Debt-ridden dog
Another member of the ‘most hated’ list is breakdown and insurance firm AA (LSE: AA). Despite recovering slightly in the first few months of 2019, AA’s shares — like those of Pearson — have reverted back to their downward trajectory in recent weeks. They’re now down by more than 50% in the last 12 months alone.
With a valuation only slightly above £350m, this leaves the one-time FTSE 250 member rapidly approaching small-cap territory.
As market participants continuing to bet against AA, it looks like it’s value might shrink again. It’s now the joint second most shorted stock on the London Stock Exchange, according to shorttracker.co.uk.
That’s not altogether surprising when you consider the £2.6bn net debt the company still carries, dwindling membership numbers, and huge competition from rivals, particularly in the insurance business.
A price-to-earnings (P/E) ratio of just 4 for the current financial year might be sufficiently enticing for the bravest of contrarians, but I can’t help thinking investors should leave this one to the traders. The forecast 3.4% dividend yield can be easily beaten elsewhere.
