A high level of short interest is the clearest indication of a company being unloved and out of favour. While this is often fundamentally justified, Alex Wright outlines why shorted stocks can provide a contrarian signal and where he believes the market is currently failing to recognise the potential for a future recovery.
- Contrarian investors go against the herd, buying unloved stocks shunned by the broader market.
- A clear indication of a company being viewed negatively by others is a large proportion of investors shorting a stock.
- This is often justified, but in the case of Ultra Electronics and Pearson, a troubled past may be obscuring better times ahead.
As a contrarian, I like to invest in stocks which are deeply out of favour with other investors. When the market consensus becomes negatively skewed towards a company, behavioural biases mean investors can be slow to react to positive change, which is what gives us a chance of getting ahead of the market.
A clear indication of a company being viewed negatively by the market is a large proportion of investors shorting a stock (betting on a decline in its share price). High short interest provides a contrarian nudge - a prompt to investigate the stock in case negative sentiment is obscuring positive change.
I would not advocate investing purely on the basis of a company being highly shorted. High short interest means a cohort of investors believe something is seriously wrong with the business, and when they are right, shareholders can sometimes experience a significant loss of capital.
The UK’s most shorted stocks
|Company||% of stock held short|
|Arrow Global Group||10.9|
|Jupiter Fund Management||9.7|
|Marks & Spencer||9.2|
Source: Financial Conduct Authority, accessed 9 May 2019. https://www.fca.org.uk/markets/short-selling/notification-and-disclosure-net-short-positions
If a company I am interested in is highly shorted, I make sure I understand the reasons, and the negative scenario that others are expecting to play out. We can test this short ‘thesis’ with in-depth research and due diligence. By speaking to customers, competitors, suppliers and industry experts, we may be able to come to a different view of the company’s future, one which suggests that recovery is more likely than deterioration.
A different perspective
While I might share the market’s negative outlook towards many of these highly shorted companies, in the case of Ultra Electronics and Pearson - both holdings in the Fidelity Special Situations Fund and Fidelity Special Values PLC - I believe that while both companies have had major issues in the past, they have a more positive future ahead of them.
&FTSE 100 education provider Pearson had a succession of profit warnings between 2015 and 2017, as a result of a declining physical textbook market and lower number of enrolments into education programmes amid rising employment. This has left many investors believing the company is in a prolonged structural downturn. Today as much as £500m worth of shares are being borrowed by short sellers.
What I believe they are missing is the enormous investment Pearson has been making into digital education services and the positive effect this could have on the company. While the transition away from physical text books towards digital services will take time and will have further ups and downs, investors willing to be patient could see a transformation of the value of their shareholding. While the UK market lacks many technology leaders, in Pearson it may soon be able to boast the world’s leading digital education provider.
Ultra Electronics is a FTSE 250 defence equipment company, and like Pearson is among the most shorted UK stocks. Those shorting the company have argued that they pursued aggressive accounting policies under the previous CEO, exaggerating profitability, and that the company can’t grow organically. However, the latest set of results suggest that these accounting policies can be unwound, key markets are improving meaningfully, and organic growth is returning.
Like Pearson, I expect scepticism towards the company to recede over time. As more attention is given to the high-quality portfolio of defence assets that Ultra Electronics owns, this has the potential to lead to a re-rating of its share price over time.
More on Fidelity Special Values PLC (UK)
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. The Fidelity Special Situations Fund and Fidelity Special Values PLC use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. They also invest more than other funds in smaller companies, which can carry a higher risk because the share prices may be more volatile than those of larger companies. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.