Kwalwasser
Hopeton Morrison, Contributor
EDWARD KWALWASSER, executive vice president of the New York Stock Exchange last week advocated a practice commonly referred to as 'selling short' for the Jamaica Stock Exchange (JSE).
He was speaking at the JSE's 35th Anniversary Symposium that focused on 'Gearing Jamaican Companies for the 21st Century'. In an expertly delivered and well received presentation, he commended the impressive rally of the local market in first quarter 2004 and added that this came against the background of many emerging markets that had faltered in the process. He also commended the announced arrangement between the Jamaican and Trinidad and Tobago exchanges to offer a broader and deeper market for Jamaican, Trinidadian and other Caribbean securities.
Mr. Kwalwasser's rather measured and somewhat controversial recommendation guides our discussion this week. What really is short selling? Short selling is one of those strategies that investors can use to increase their gains. Needless to say it also increases an investor's risk. In fact, short selling is often used by sophisticated investors in conjunction with another higher risk strategy known as 'Buying Warrants'. Both strategies are based on calculated gambles that a stock will either lose significant value very quickly opening opportunity for a short sale or increase in value very quickly here presenting opportunity for buying a warrant.
INCREASE IN VALUE
While the average investor will buy a stock that she expects to increase in value there are others, especially in the more developed markets who will invest in a 'contrary' direction. For example, some will seek to sell while others are buying if they expect a stock's price to lose substantial value and vice versa if the reverse conditions apply.
The practice is to borrow shares that you don't own from a broker. These shares are sold and the money retained by you until the anticipated drop in share price occurs. At this stage you re-enter the market by repurchasing the shares at the lower price, give them back to the broker (remember that you borrowed them in the first place). You are also required to pay interest and a commission to the broker here. Your value is the gain made between the higher selling price and the lower buy back prices.
The practice of buying back the stock at a lower price is known as "covering the short position". If successfully implemented you would have made money without putting up one cent of your own money.
The risks in the practice are obvious and usually happen when two events occur. In the first place if the price goes up rather than down and in the second if the drop in the price takes a longer time than expected. While the loss is self-evident where the stock's price goes up, the longer than expected drop in price means that the interest that you owe to the broker increases.
Short selling can sometimes drive a stock's price even higher than its value. This occurs in the event that a stock that has been shorted by several investors starts a steep rise resulting in a mad scramble by these short sellers to cover their positions. The intense buying that results often causes the price to appreciate significantly higher than the market valuation. When this happens the term in the industry is that sellers are caught in a 'squeeze'.
In those highly sophisticated markets where the practice is open and legal such as Kwalwasser's New York Stock Exchange (NYSE), once a month the Wall Street Journal and other business papers report on those stocks that have been sold short but are yet to be repurchased. The level of activity here becomes a barometer for stakeholders including analysts, brokers and the more sophisticated investors who engage in their own calculated inferences here as to which stocks are expected to fall and by what fraction of decline.
It is important to note that short selling is not necessarily a statement that the market is about to become bearish and in fact heavy short sells is often a bullish sign as at some point in the near future short positions must be covered.
In the same way that investors go short they can engage in the opposite positions by buying warrants. A warrant offers a guarantee by the broker to the investor that a stock will be offered at a fixed price for a set period of time and are purchased when the stock price is expected to go up. These warrants are usually sold for a small fee.
We take a simple example. With all the major expansion plans being put in place for Kingston Harbour, what if an investor, say Mr. John Prudence, selects Kingston Wharves (which closed at $4 last Tuesday) as one with high growth possibilities? Mr. Prudence is of the view that in five years' time, not only will Kingston Harbour become a major transhipment facility but, with the clean up of the harbour, cruise ships will start docking at Victoria Pier in downtown Kingston again.
He offers his broker 50 cents per share to purchase Kingston Wharves at $30 per share in five years. If in five years' time the price of the stock rises to $75 instead (hardly improbable in the context of how the JSE index has performed in recent years), and John Prudence exercises his warrant he makes a healthy $44.50 on each share calculated thus: ($75-($30 + .50). These warrants, sometimes tradable instruments themselves and a designation 'wt' in the stock tables in the newspaper, denotes a quotation for a tradable warrant.
Another high risk strategy for equity investors is 'Buying on Margin'. Here again, an investor is borrowing from his broker usually up to a half of the purchase price of a stock. Let us say you purchased one of the big winners on the local JSE last year, BNS which closed on $48.70 last Tuesday. An investor, we call her Mary Rich, purchases 1,000 of BNS, using a margin account totalling $48,700. She borrows a half of the purchase price ($24,350) from her broker. If BNS rises 50 per cent over the next 12 months the total investment would stand at $73,050. She repays the broker the amount borrowed leaving her with a total of $48,700. She has effectively used half of the funds required (her own funds of $24,350) to make twice that much (less fees). Significantly, if she had utilised all of her own funds in this investment her returns would be 50 per cent less fees ($24,350 on $48,700 invested).
So, she has accumulated significant additional value using borrowed money.
Buying on margin speaks to the financial principle of leveraging similar to the principles used in short selling above. The principle applicable in all three approaches, short selling, warrants and margins speak to applying increased financial power with limited amounts of cash. Like any high risk investment activity, the risks can also turn the other way. In the case of margin purchases, Mary loses money if the price of the stock drops.
Because the practice of margin buying is so risky, exchanges such as Kwalwasser's NYSE in association with the National Association of Securities Dealers (NASD) have put in place measures to prevent or minimise the risk to the exchange. Investors are required to maintain a margin account balance of a minimum 25 per cent of the purchase price of any stock purchased on margin. In the event that the market value of the investment drops below this required minimum, a margin call is issued and the investor is required to meet the call by putting money into the account to meet the required minimum. Another option is to sell the stock and pay back the broker resulting in the investor's loss.
MARGIN REQUIREMENT
Taking an example, let us say that an investor purchased 20,000 of a stock valued at $1 at margin. If those shares declined from $20,000 to $3,500 they are now worth only 17.5 per cent of the original purchase value. If the broker has set a 25 per cent margin requirement, this means that the investor should have a minimum of $5,000 value in the account at all times. It means then that the investor will have to add another $1,500 to bring the account up to the required minimum.
With the imminent expansion of the JSE joining up with the TTSE it is only a matter of time before more of those experienced investors (to which we refer above) enter our markets from other markets. It will not be long before our own Caribbean investors engage in more of these high risk investment strategies.
Hopeton Morrison is general manager of St. Thomas Co-operative Credit Union Ltd. and lecturer in the School of Business Administration at the University of Technology. Please send comments and questions to: hmorrison@stccu.com
