Not every short-seller has had a wonderful week

Short-sellers made a fortune betting against Carillion earlier this week. But they don’t always win. John Stepek looks at the risks of short-selling, and a bet that turned bad.


For every short seller's success, there are a lot of failures
(Image credit: © 2016 Bloomberg Finance LP)

This week, short-sellers made a huge amount of money on one of the most-shorted stocks in the UK.

Support services group Carillion saw its share price topple by more than 70% this week and until there's more clarity on its future, it's hard to see where the bottom lies for this one.

But lest you think it's all strawberries, cream and champers for the shorts, this week also saw a lot of them get stung on another heavily shorted company.

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Enter Premier Oil...

Short-selling is a risky business

As we discussed earlier this week

There is a widespread element of distaste for short-sellers. This, I feel, is unfair. Dislike of short-sellers stems from a number of reasons, almost all of them related to the fact that short-sellers often embarrass a lot of different powerful groups.

Anyone who blithely held Carillion, for example, in the face of all that short interest, will now be feeling somewhat chastened, and keen to find someone else to blame for their error. Short-sellers make a good target.

Regulators find them useful scapegoats too, when sectors that they claimed to be entirely sound turn out to be as rotten as termite-infested timber. Closely related to this is the dislike that governments have for them (witness short-selling bans during financial panics).

All in all, they are convenient to have around when something goes hideously wrong and you want to blame it on someone else mischief-making, parasitic speculators make a great target.

But I have a lot of sympathy for short-sellers. It's not easy to make money by short-selling. So you have to articulate your case far more clearly than many "long-only" investors. Put bluntly, long investors can be lazy. Short-sellers can't afford to be. They might be dreadful speculators, but they're dreadful speculators with a work ethic.

And when their bets go wrong, it's pretty painful as many of them found out later this week.

If you're a short-seller, you ultimately want to find a company whose share price is potentially heading towards a big fat zero. That's your holy grail.

So what makes the perfect short-selling target? One key characteristic is companies that are carrying a lot of debt or rather, companies that are carrying enough debt that they rely on being lucky, or on the indulgence of their creditors, to keep afloat. That sort of precarious situation is catnip to short-sellers.

You'd also want this company to be in a sector where there's a good chance that its future revenues are going to fall short of expectations. In fact, what you really want is a company that loaded up on debt based on revenues coming in at one level, and where revenues are now likely to horribly disappoint.

Hmm. Where would you find such a sector?

The tricky thing about betting on oil stocks either way

So there were bound to be some particularly vulnerable-looking stocks in the sector. And Premier Oil was one of the bigger ones to fit the bill.

The company has recently organised a financial restructuring after "a year of wrangling with lenders and bondholders", as the FT puts it. And it still carries more than £2bn in debt.

The ultra-forgiving world of zero-percent interest rates has undoubtedly helped it to stay afloat yield-hungry banks and lenders aren't as keen to pull the plug as they might be if better offers were on the table but it's not a position any company particularly wants to be in.

Of course, the tricky thing about oil stocks is that you can never be quite sure of when they might strike it rich. That's the problem for "long" investors in oil stocks they might be waiting in hope forever but it's also the problem for short-sellers. You never know when your rational case for being short could be upended by a lucky break.

And that's what happened to Premier this week. On Wednesday it announced a huge oil find in Mexican deep waters. It's one of the biggest such discoveries in the last five years, and a lot bigger than expected.

Premier owns 25% of the block. It was part of a consortium with Talos Energy and Mexico's Sierra Oil and Gas, which was awarded the exploration rights by Mexico's government in 2015.

As a result, the shares rocketed by around 35%. That would have been painful for anyone on the short side. And while there's still scope for future disappointment, it looks a lot more dangerous to be betting on the share price to tank from here.

To be clear, that's not a recommendation to buy into Premier it's not a stock I know a huge amount about, so do your own research but it's just worth noting: for every fantastic punt the short-sellers take flak for, there's a load of them nursing their burnt fingers on some other short that's gone wrong.

There are no sure things in markets. And that's the only reason the whole system works.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.