Sino-Forest – short covering or short squeeze?

Sino-Forest (TSE:TRE) has been one of the most active financial news stories over the past few weeks. In this report, we’ll see that shorts have since covered a significant portion of their positions. We’ll also take a “deep dive” into the intraday securities lending trading activity on June 20th to ascertain whether the drop in stock on loan is driven by profit taking or from a ‘recall’ short squeeze.

The background

As Bloomberg reported on June 3rd, the price of Sino-Forest fell the most since 2008 after the short seller Carson C Block said that Sino-Forest has overstated timberland holdings and production in China. Subsequently, the share price has dropped 89%.

The short interest

Short interest in Sino-Forest peaked at 35% of the shares outstanding on June 2nd. This is the equivalent of 86.2 million shares. As the below chart illustrates, the short interest has dropped along with share price and is now just under 20% of the shares outstanding.

Given the negative publicity in the name, conventional wisdom would say that the short interest would be increasing as the share price falls.

Short covering or short squeeze?

It is important to understand the main drivers behind the fall in short interest. Since 2 June, the percentage of shares outstanding on loan has declined 44%. Clearly in the immediate aftermath of the Muddy Water allegations and subsequent share price collapse, it is rational to assume that some short selling investors chose to close out their positions.

Some sellers may have been forced to close positions due to lender ‘recalls’. A recall occurs when the borrower sells their position and the short seller cannot replace their borrowed shares from another source. The short seller is forced to close out their position, and return to the lender the shares purchased – if the recall is large enough it can cause a spike in the share price as short sellers rush to cover positions. Our Utilization metric measures the percentage of lendable supply that is out on loan – the higher the number the higher the risk of a recall squeeze.

With the long inventory dropping almost 20% since June 1st it is logical to assume that some of the short covering was down to lender recalls. But the rate at which long holders are reducing their positions has been slow enough to avoid a recall short squeeze.

To investigate further, we have run an intra-day analysis of securities lending transactions to see if we could detect signs of recall. The chart below depicts an analysis of trade flow throughout June 20th. During the morning, we saw new loans increase from the previous day’s close of 20.57% shares outstanding to just under 21.5% (an overall increase of 2.1 million shares). The drop to 18.5%, halfway through the day, appears to have been a mixture of short covering and recalls as the borrow rates of the trades being returned range from relatively cheap to relatively expensive.

Towards the end of the day we see a small pick-up in loans to close at 19.49% of shares outstanding – a drop of just over 1% from the previous day.

Data Explorers Utilization

Short selling is dependent on being able to borrow shares to make delivery to the other side of the trade (i.e. the buyer). If there are limited shares available to borrow then room for short interest to grow is constrained.

In the case of Sino-Forest we saw the utilization level (the amount of short sales in relation to the amount of shares made available to borrow) was above 96% at the beginning of June and has fallen to 87% as of June 20th (see below chart). In relative terms this is still a very high level of utilization.

 

 Bottom line

Although 19.49% of the total shares still out on loan, short interest has almost retreated back to the levels seen before the Muddy Waters report was released. With Utilization remaining very high and if institutional owners who lend plan to further reduce their holding and recall additional stock, short sellers could be facing further recall pressure.