Fairfax And The Big Short

This story features NEWCREST MINING LIMITED, and other companies. For more info SHARE ANALYSIS: NCM

By Greg Peel

The third most shorted stock in the ASX 200 at present is Newcrest Mining ((NCM)), with 4.6% of its market cap held as short positions by the market. The second is Perpetual ((PPT)) at 5.0%. But way, way out in front is Fairfax Media ((FXJ)) with 11.5% of its market cap held as short positions by the market, as reported by ASIC.

Analysts at Morgan Stanley are somewhat perplexed. Sure, the global media sector is undergoing structural change, such that the “old media” of newspapers and free-to-air television is being replaced by the “new media” of the internet and cable. But companies in the same boat, such as West Australian Newspapers ((WAN)) and APN News & Media ((APN)) are shorted by only 2.7% and 0.9% respectively. Indeed, there's not a lot of difference between these numbers and the short on new media company Seek ((SEK)), for example, with 0.7%.

And sure, Fairfax was in a some degree of trouble at the height of the GFC, causing the value of its hybrid debt issue to fall to 50 cents in the dollar. But the stock price, and the value of the debt, has since recovered reasonably well.

So why the big short? Morgan Stanley remains positive on Fairfax, suggesting that why structural issues remain the stock is currently undervalued. What the analysts do conclude is that with such a big short position in place, there is scope for heightened volatility in the movement of the FXJ price. If the shorts start to lose faith, an upside scramble could occur, they imply in a report this morning.

Wrong.

To understand why, lets look at second and third place. Now Perpetual is a company which has struggled to maintain funds under management as a result of the GFC. One might be able to conclude these are legitimate short positions from hedge funds, or maybe there's something going on between the whole wealth management play given the AMP ((AMP)) and AXA AP ((AXA)) thing. But let's leave Perpetual. Let's look at Newcrest.

The less experienced in the market immediately assume anyone short stock must be an evil hedge fund hellbent on screwing smaller investors. If this is the case, why Newcrest? You'd be hard pressed to find anyone at present who doesn't believe gold is in a secular uptrend. But then perhaps the secret lies in the age old trader takeover strategy – the one where you buy the target, in this case Lihir Gold ((LGL)), and short the suitor (Newcrest) as an offset. The strategy assumes a premium will be paid by the suitor for the target, thus overvaluing the target and costing the suitor. One price rises and the other falls, and you're a winner.

Is this evil? There are a plethora of “long-short” funds out there who don't even need takeovers to play such spreads. Maybe they think miners are undervalued and banks overvalued, so they buy miners and short banks, keeping a net zero exposure.

And then there are derivatives market-makers. No – they don't have to be evil either. If Joe Investor wants to buy put options as protection on his stocks, he has to buy them from someone. A proprietary market-maker will sell to Joe and then hedge his own risk by shorting an amount of stock. The market-maker is then short as a hedge, not as an attacking ploy.

So back to Fairfax. Remember that hybrid bond issue I mentioned? A hybrid begins life as a corporate bond, paying a coupon (in this case a good one) but it may be converted to an equity at a later date if the stock price rallies sufficiently. Hence such an animal is really a bond with a call option attached. Fairfax has long been an issuer of hybrids.

If you are a hedge fund, or maybe even a mutual fund or investor, you may like the idea of holding the bond part (Fairfax has never defaulted) but don't wish to be holding the equity exposure. What you can do is buy the hybrid and then sell an amount of Fairfax stock short to a level which reflects the risk of the embedded call option (this is known in market parlance as a delta hedge).

If the Fairfax stock price rises it stands to reason the bond price will also rise (less chance of default) and the value of the call option will rise. In order to hedge the increased equity exposure, more stock needs to be sold.

It is understood in the market that many funds have bought the Fairfax debt issue at cheap levels (high yield) assuming the company will not go under, while hedging out the equity exposure through short-selling.

The “big short” in Fairfax represents that hedge. Shareholders need not be concerned. Indeed, the last thing the shorts want to happen is for Fairfax to collapse.

What's more, if FXJ does shoot up, the shorts will need to sell more. If it falls, they will buy back. As long as they maintain a position in the bonds, they will actually act to reduce volatility, not increase it.

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