Ignore Home Retail's surging share price: nothing has changed

At MoneyWeek we've been keeping a close eye on Home Retail Group shares in recent weeks. We don't see it as a quality business, but we think it might be a possible value investing opportunity at the right price.

Investors have dumped the stock on fears that its business model and high operating costs have no future in the cutthroat world of retail. Plunging sales and a slashed dividend have added to the misery.

But as we've said before, while the pessimism may be justified in the long run it can create short-term money making opportunities. It's hard for us to say whether or not Home Retail is a long-term winner, but if it can survive it will have a value.

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The trouble is finding out what that value is. A few weeks ago we talked about what represented a really depressed value for Home Retail. We looked at the approach of legendary value investor Benjamin Graham who tried to buy stocks for less than their net working capital (basically stocks, debtors and cash less all liabilities). For Home Retail this value is 49p per share.

Last Friday, the shares hit a five-year low of 68p, but we have seen the shares rally sharply to 93p today.

So what's suddenly changed? In short, we wouldn't get overly excited.

Trading at Argos looks as though it has stabilised, when many analysts were much more pessimistic. Also, the all-important City forecasts have not been marked down again. Some newspapers cite mutterings about a possible private equity bid for the company.

But the most likely explanation is what is known as a 'short squeeze'. It seems that quite a few hedge funds have placed bets on things getting a lot worse for Home Retail. They've borrowed shares from other investors to sell with the hope of buying them back at a lower price and making a nice profit.

When it turned out that trading hasn't deteriorated further yet it's difficult to make a case for the share price to fall further. So what we are seeing today is very similar to the panic selling that you can see in a stock market crash, except prices are rising rather than falling.

Some short sellers, fearful of losing money (as the share price rises above the price they sold at) are frantically buying back shares to limit their losses. The more of them that do this, the higher the share price will rise until losses have been contained.

This sort of activity causes the sort of violent swings in share prices that put many people off putting their money in the stock market in the first place. It makes the market look like the casino that it has become.

But if we return to the real world, what exactly does today's announcement mean for Home Retail?

The answer is very little. Management still expects to make the same amount of money in 2012 as it did six weeks ago. The fact that Argos' sales are virtually unchanged might come as a relief to long-term shareholders, but this time last year they were falling at an annual rate of nearly 10%, so the comparable sales base was quite weak.

There's some good news. 'Click & collect' and internet sales are becoming a bigger part of Argos' business, but it still has all the costs and rents of nearly 750 stores. Homebase faces a similar cost problem.

So nothing fundamental has changed. Profits are not going to be higher than people were expecting. Home Retail still has lots of off-balance sheet debt and a low fixed charge cover. Yet the stock is worth 25% more than it was yesterday.

At 93p, the shares trade on 18.2 times 2012 forecast earnings with a prospective dividend yield of 3.6% - that's no bargain and prices in a hefty amount of profit improvement in the years ahead. We wouldn't be buyers here.

Once the short squeeze is over, we wouldn't be surprised if the shares begin to fall again as artificial buying interest drops away. We may be too cautious in looking at working capital values as guides for when to buy distressed businesses like Home Retail, but it's important not to lose money. With the UK consumer and Home Retail's business model still under pressure, you may get another chance to buy before too long.