A look at the short positions on the Tel Aviv Stock Exchange reveals something interesting: with an exposure of NIS 450 million, the most popular company among the short sellers is Israel Chemicals (TASE: CHIM). On the face of it, that's a strange statistic. What are the short sellers doing in Israel Chemicals?
With potash prices surging, the company is going through one of its most profitable periods ever. The graph of its stock price tells a story of satisfaction on the part of its shareholders. So what is the rush of short selling all about? To answer that question, you have to examine the trend in the short position over time.
This shows two main trends. In the first phase, which lasted right through 2007, the short players learned the hard way that selling Israel Chemicals short is not especially profitable. This was the speculative phase. The short interest shrank as the share price went up, reaching a low in November. Then began the second phase: short interest rose again, doing so sharply and rapidly from January 2008. This we will call the rational phase.
What happened at the end of 2007 to make the short balance in Israel Chemicals rise? It's true that the share price fell sharply at that time, but the movement was not so great as to justify such a leap in the short players' confidence. What's more, the position continued growing even when the share price rose consistently. So again, what was the trigger at the end of 2007? The answer to that question lies in a comparison of the short trend in Israel Chemicals with that in its parent company, Israel Corp. (TASE: ILCO).
During the speculative phase, Israel Corp. behaved much like Israel Chemicals. Shares sold short grew as the stock price rose, but then a clear deviation took place. While both stocks continued to rise, the short balance in Israel Corp. did not resume its rise in the rational phase, and remained minimal (about 2,500 shares on average).
Short on Israel Chemicals, long on Israel Corp.: Why?
This divergence between the short positions in Israel Chemicals and Israel Corp. tells us something important, and indicates a definite course of action on the part of the players. They began expanding the short position in Israel Chemicals substantially, but refrained from doing so in Israel Corp. What made them do that?
In my opinion, the trigger lies in the sell side analyses that started to appear at that time. If my memory serves me well, it was Yuval Zehira of IBI who, in November 2007, first pointed out the large discount represented by the market cap of Israel Corp. in relation to the value of its holdings.
Yuval Ben Zeev, research manager at Clal Finance Batucha, was the second. In a report he published in January 2008, Ben Zeev chose a headline the press could not ignore: "End of Season Prices - buy Israel Corp. at the value of the public companies and get the private companies free." "End of Season," "free," these are expressions that greatly appeal to Israelis who like a deal.
After Ben Zeev came several more analyses that sold the same story. In March 2008, Deutsche Bank pointed to a 27% discount, and explicitly mentioned the possibility of an arbitrage play, and in April 2008, HSBC declared that the discount was 64% (wouldn't you know). They said that, more than ever, Israel Corp. was traded at a deep discount, and that this was an opportunity to buy quality assets at rock bottom process.
To my mind, the reports made a decisive contribution to the short positions in the two companies. But before going into that, I will try to explain briefly for less experienced readers how this "discount" is quantified and how it arises.
Israel Corp.'s main holdings are Israel Chemicals (52%), Oil Refineries (45%), Tower Semiconductor (33%), shipping line Zim, power plants in Latin America, and the car venture with Chinese company Chery. The first three holdings are public companies, and their aggregate market cap is NIS 6,289 for every diluted Israel Corp. share. That share is traded at a price of NIS 4,440, giving a discount of 30%.
That, however, is not exact. Israel Corp. also has debt on its balance sheet (NIS 861 per share, after offsetting cash and deposits) which presumably accounts for some of the difference. If we deduct the debt from the value of the listed holdings, we get a discount of 18%.
Even that isn't quite correct. Israel Corp. has other important holdings. Zim, for example, is valued by the analysts at some $1.5 billion (after being sold by the State of Israel in 2004 for $240 million.) Let's assume that the analysts are exaggerating the value of Zim.
If we look at the shipping sector since 2004, we find that the market values of the companies in it have doubled, on average. If we are generous to the Ofer family and triple the value of their acquisition, we get an estimated value of about $750 million, which is NIS 355 for every Israel Corp. share (at a rate of NIS 3.6/$).
Adding the value of Zim to those of the first three holdings, and deducting the net debt, we reach a price of NIS 5,782 for Israel Corp. share, and the discount rises to 25%.
There's no doubt that, in principle, a discount like that can be exploited to make a profit. This is even allowing for the fact that, for several good reasons, investment companies are generally valued at a discount to their holdings. The normal discount is around 10%.
But Israel Chemicals' high price - maybe too high - is disturbing. There are those who contend that world commodity prices, that of potash among them, contain a speculative component. For those who believe in Israel Chemicals it is indeed worthwhile buying it through Israel Corp., but either way, the risk of losses because of that speculative component remains high.
Rational short players therefore prefer to neutralize the risk in Israel Chemicals, and the way to do that is to borrow Israel Chemicals' shares and sell them short, covering the position by going long on Israel Corp. They construct an artificial stub, that is, a synthetic security representing a certain segment of a company's activity. In effect, they buy Israel Corp. without Israel Chemicals.
In the light of this, the trend described above becomes clearer. The deviation that appeared in the second, rational, phase apparently indicates arbitrage players trying to exploit the discount by building a contra position: short on Israel Chemicals and long on Israel Corp., in the appropriate proportions.
Is the market efficient enough?
The trouble is that, since then, to the short sellers' consternation, the discount as actually widened, and the securities borrowers, those same arbitrage sellers, have found themselves in a losing position. These paper losses must cause fear among the lenders, and when the lender is under pressure and is entitled, as is normal practice, to demand his shares back from the borrower, the borrower is left with an actual loss.
This is what happened, in my view, last month. Israel Chemicals' share price rose sharply, more strongly than the price of Israel Corp., and short positions in Israel Chemicals were reduced, as the arbitrage players who were forced to cover their short positions had to buy back shares - and lost actual money.
When I tried to get an idea of the normal borrowing terms on the market, the answer I received was that the lender always reserves the right to demand return of the borrowed securities, subject to a short notice period.
If the market allowed easy and quick rollover of positions (that is, finding a replacement lender immediately), or if it were possible to find a lender prepared, with suitable collateral, to commit to a long loan term (say, two to three years), this game would become much safer. As things stand, the market is not efficient enough, it's hard to determine when the discount will shrink, and the rationale of the stub described is undermined.
Rafi Nelson blogs, in Hebrew, at http://www.tapuz.co.il/blog/userBlog.asp?FolderName=rafinelson
Published by Globes [online], Israel business news - www.globes.co.il - on May 1, 2008
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