Squeezing The Yield Shorts

Not every buy and hold investor has the savvy and steady temperament to be as successful as Warren Buffett. Similarly, not every short seller is insightful and nimble enough to match Jim Chanos’ storied success.

My problem is bear arguments don’t often get the same level of scrutiny as bullish ones. When investors see a pile of short interest against a stock, they all too often assume there’s something really bad they don’t know about. And if the price action moves against them, they panic and bail out.

That kind of selling is the critical fuel for firing up short sellers’ returns. Short sellers essentially borrow stock to sell it. They make money when they can buy the stock back at a lower price.

When enough people short a stock, it’s the equivalent of a wave of sells and the price goes lower. But they only make real money if those with long positions exit. Short sellers do best if they can drive the naïve and fearful to panic. And the investment webosphere has given them the ideal vehicle to sow such emotions.

The past year’s bear raid on Linn Energy LLC (NSDQ: LINE) is a textbook case. Spearheaded by investment research firm Hedgeye Risk Management with a little help from Barron’s, the bears began their attack by insinuating the oil and gas producer’s business plan was nothing less than fraudulent.

The attack stepped up in early July when Linn disclosed an “informal investigation” into its accounting by the Securities and Exchange Commission. The probe was part of the SEC’s approval process for Linn’s acquisition of the former Berry Petroleum. But it was quickly painted as the start of something that would inevitably end in disaster for investors in Linn, as well as other high yielding energy producers.

The piling on intensified the panic, pushing Linn’s unit price hit as low as $20.35 on July 5. In the end, the charges proved to be a phantom menace. The SEC approved the Berry merger, tacitly confirming the fraud charges were baseless. And the company has posted strong operating results, with another set of solid numbers expected on February 27.

The evaporation of the bear case has pushed Linn’s unit price back to the mid-30s, intensifying a squeeze on the still sizeable number of short sellers. And it’s likely to recapture its old range in the high 30s/low 40s once it resumes regular distribution increases.

In the end, the bears did not achieve their ultimate goal of breaking apart Linn’s merger with Berry, as management stood its ground. Recovery was therefore inevitable. Short sellers who sold early made a killing. Those who piled on and stayed too late had their heads handed to them.

Learning from Linn

My table highlights four dividend-paying stocks heavily shorted now. Shorting yield has been popular since last May, when the US Federal Reserve began talking about “tapering” off bond purchases.

The mistaken assumption then was that stocks that pay dividends are little more than bond substitutes, and just like bonds will sell off sharply if interest rates rise. The theory proved mushy when most posted solid gains last year. And now that the Fed is actually tapering, losses have actually increased as benchmark interest rates have dropped.

Ironically, that hasn’t dimmed the appeal of shorting yield, and particularly stocks in industries with perceived weakness. The short bet is basically that operating results will worsen enough to force dividend cuts, triggering selloffs.

There’s another side to the story, however. Mainly, heavy short interest has depressed these stocks to levels that reflect pretty much rock bottom expectations. If the underlying companies exceed them, shares will rebound.

Short squeezes develop when enough short sellers try to exit a position at the same time. Their buying pushes the stock higher, which further increases the pressure to exit. Damage from squeezes is particularly severe for those using margin, i.e. borrowing to leverage or magnify gains.

This push and pull on short sellers has driven at least some of the price action in Linn in recent months. Better than expected news could do the same for the stocks in the table as well—triggering windfall gains for buyers.

The key is to know more than the average guy on the other side of the trade. No stock is heavily shorted unless there’s an obvious weakness, just as no stock yields 10 percent or more unless its dividend safety is being questioned. You need to know why people are betting against the company, and have sufficient grounds to wager they’re wrong.

During the depths of Linn’s summer 2013 selloff, my partner at Capitalist Times Elliott Gue penned a number of articles for our readers. He highlighted the company’s strengths, explained why the shorts’ charges were trumped up and urged investors to stick with positions and not succumb to the building panic.

Elliott was able to take that position because he’s studied Linn intensely since its initial public offering in January 2006. He was one of a tiny handful to recommend the stock at its all-time nadir of barely $10 per unit in December 2008, putting his own money behind it as well. Linn today is a recommendation in our premium advisory Energy and Income Advisor.

The key is he knew a lot more than the average bear about Linn, including chief antagonist Hedgeye. Those who followed his advice last summer at a minimum avoided the critical mistake of selling out at a panic bottom. Some were able to pick up a great company on the cheap.

The Next Linn

I’m similarly confident that we know considerably more about the four stocks in the table than does the typical short seller. In a market where short term moves are based on imperfect information, knowledge is no guarantee.

Short squeezes are, however, going to be among the most profitable trades in the dividend paying stock universe this year. And risks of betting on one emerging aren’t as dire as it may appear at first glance.

Shares of CenturyLink (NYSE: CTL) lost roughly a quarter of their value on Valentine’s Day 2013, when the company cut its dividend by a little more than 25 percent.

In contrast, Exelon Corp (NYSE: EXC) shares are basically flat now with where they were February 6 of last year, the day before the company cut its dividend by 41 percent.

CenturyLink was a profitable short sale because its cut was unexpected and its share price had to adjust to the news. In contrast, Exelon’s move was long expected and therefore more than priced in. Short sellers got little or nothing for their effort.

That was also the case with FirstEnergy (NYSE: FE) last month, as the stock’s price basically has been flat since the company cut its dividend January 21. Those betting against the power utility and its payout were right in the end. But because the outcome was widely expected, there was little or no payoff.

The key questions for those betting on potential squeezes are is it likely the company will avoid a dividend cut, and if they don’t is one already priced in? If the answer to either is yes, there are the makings of a potential short squeeze. And that’s definitely the case with all four of these companies.

The stock with the least near-term risk on this list is clearly Exelon. You won’t find many stocks with a greater bearish consensus among analysts. Of the 27 covering it, there are no buys, 20 holds and 7 sells. That’s basically a reflection of negative sentiment on wholesale power prices, and Exelon is the utility most aggressively positioned in that business.

On the other hand, insiders are bullish, with directors and executives boosting holdings of the power utility by nearly 9 percent in the past six months. And numbers the company has already announced fourth quarter 2013 earnings and guidance that clearly support the current level of payout.

I have more on Exelon in the newly posted February issue of Conrad’s Utility Investor. Similarly, the remaining short interest in Linn Energy smacks of stubbornness. And we could see severe punishment meted out if the company’s fourth quarter results and guidance next week build on the third quarter’s progress, as seems likely.

Frontier’s (NSDQ: FTR) spiky price action over the past year clearly demonstrates the impact of aggressive short selling that’s been periodically rewarded and then badly burned.

This will eventually end in one of two ways. The worst case is high debt and shrinking revenue will force another dividend cut. The best is strategic moves—such as the proposed $2 billion purchase of AT&T’s (NYSE: T) wireline network in Connecticut—will pay off with stable to growing revenue.

I doubt very much we’ll see either outcome on February 24 when fourth quarter numbers are released and the company gives guidance. But whatever the case it’s hard to argue Frontier at this price doesn’t already reflect expectations of a dividend cut.

That’s also true of Just Energy (TSX: JE, NYSE: JE), though next week’s release of fiscal third quarter 2014 results will represent a day of reckoning of sorts for the energy marketer. Management has long claimed the winter quarters would be a turning point for cash flow coverage of dividends, as recent aggressive customer acquisition at last produces promised revenue.

That’s the bar it will have to meet with the upcoming numbers. And how well it does will be determine whether distribution coverage will improve and the current monthly payout of 7 cents Canadian will hold.

Just Energy’s extremely volatile action over the past year is clearly affected by the huge short volume against the stock. Interestingly, short interest on the Canadian side of the border is much lower, at 4.24 percent of float and 4.4 average trading days.

Note that all four companies are tracked regularly in Conrad’s Utility Advisor. Just Energy and Linn are also part of our Energy and Income coverage universe.