In the world of investing, shorting stocks can be a tempting strategy, particularly when targeting small-cap companies that have seen better days. While the allure of profiting from further declines in already beaten-down stocks may seem appealing, it’s crucial for investors to recognize the significant risks associated with shorting small caps in such circumstances.
Hotel Chocolat Gets Acquired for 170% Premium
Today (16th November 2023) with Hotel Chocolat (LON:HOTC) trading at 139p (£191m) we have a blockbuster takeover bid at 375p, a 170% premium, from Mars. Chocolate giant Mars is bidding a remarkable 375p cash (£534m total) for Hotel Chocolat, a deal which is agreed by HOTC management (who have controlling stakes).
Congratulations to holders! HOTC didn’t stack up as a standalone company, and performance in recent years has been poor. So this is a fabulous outcome, recognising the brand value. This is an astonishing 170% premium to last night’s share price! On both fundamentals and share price performance, HOTC has been a considerable disappointment, poorly managed, with failed overseas expansion, disappearing profits, and frequent profit warnings.
So why on earth is Mars buying it for £534m? It’s got to be for the value it sees in the brand. Properly managed, and with Mars financial strength, no doubt the Hotel Chocolat brand will be expanded greatly. So a good lesson learned there, that there can be value in companies beyond the pure numbers.
HOTC a good example of why it’s dangerous to be short small caps that have already taken a beating. Unless you can get a guaranteed stop (which is unlikely a lot of the time) you’re wearing a big risk.
- Limited Downside Potential: Small-cap stocks that have already experienced a significant downturn might have limited room for further declines. The risk-reward profile becomes skewed, as the potential for additional downside is constrained compared to the potential for a rebound. Investors should carefully weigh the risk of shorting stocks that have already been heavily discounted.
- Market Volatility and Unpredictability: Small-cap stocks, by their nature, are more susceptible to market volatility and unpredictable price movements. These companies often lack the stability and liquidity of larger counterparts, making their stock prices more prone to erratic swings. Shorting in such an environment amplifies the risk, as unexpected positive developments or market sentiment shifts can lead to sharp and rapid price reversals.
- Limited Availability for Shorting: Shorting small-cap stocks may be restricted by limited availability, especially if the stock is not heavily traded. Illiquidity in the market can result in challenges in executing short positions and covering them, potentially leading to unfavorable terms or missed opportunities.
- Short Squeezes and Forced Covering: Beaten-down small caps may become targets for short squeezes, where a surge in buying activity forces short sellers to cover their positions. This can result in rapid price spikes, causing significant losses for those betting on further declines. The risk of short squeezes is particularly pronounced in small-cap stocks with higher short interest.
- Elevated Risk of Corporate Actions: Companies facing financial challenges may be more susceptible to corporate actions such as mergers, acquisitions, or restructuring. These events can lead to unexpected stock price movements, catching short sellers off guard and resulting in substantial losses.
Shorting small caps full stop is complete madness. Way too risky, nobody here should be doing it, in my opinion. A takeover bid at a big premium is a massive risk. Lucian Mears told me that he once had a short on something he was convinced was about to go bust, at 1p per share. It then put out unexpected good news, and spiked up to 31p. Something similar happened to another friend, who shorted a Chinese fraud, which was then suspended. He was forced to close the short at a price named by the Chinese fraudsters, and they relieved him of a small 7-figure sum I believe.
Conclusion:
While shorting stocks can be a viable strategy in certain market conditions, shorting small caps that have already been beaten down carries heightened risks. Limited downside potential, market volatility, restricted availability for shorting, the threat of short squeezes, and the potential for unexpected corporate actions make this strategy a risky endeavor.
Investors should exercise caution and thoroughly evaluate the risk-reward dynamics before considering short positions in beaten-down small-cap stocks. Diversification, thorough research, and a clear understanding of the unique challenges associated with shorting in the small-cap space are essential for those looking to navigate these turbulent waters.
Paul Scott shorted Thomas Cook a few years ago, when it was obviously about to go bust. It spiked up from 5p to about 14p, and he was forced to close the short at a heavy loss, and it went bust shortly afterwards. It’s a nightmare area, where even specialists get hung out to dry every now and then, so not worth taking the risk. As the old saying goes, the worst you can lose is 100% on a long. On a short, the potential loss is unlimited.
