Why Eddy’s ABC copped a kicking

The ASX should obviously enforce proper disclosure of short selling using borrowed stock (if it can), but the calamity that befell ABC Learning Centres and its founder, Eddy Groves, yesterday was not really about the hocus-pocus of shorting.

Whether you sell stock that you owned, that you borrowed or that you intend to buy, you’re still selling. It is only a good idea if the price ends up being lower than it was before.

Bull markets are bad times to sell, however you do it, and for five years it has usually ended in loss. We are now in an age of selling – when getting out is more often a good idea than getting in.

Hedge funds used to profit by buying cheap stocks and riding them up; now they do it by selling expensive ones – even if they don’t own them. But it’s not just hedge funds; everybody is looking to dump their dogs.

The main lesson from yesterday’s brutal selling of ABC Learning is that this is not a good time to bark and have four legs.

Eddy Groves’s company is woofer with four legs and copped a terrible kicking. Here are the legs:

• A negative profit surprise.
• A lot of debt.
• A poor return on equity.
• A major shareholder with a big margin loan (himself).

That is what did it for Groves, combined with a market inclined to sell. Any other company with even three dog legs needs to take action immediately.

They need to issue a profit warning now, sell assets or raise equity to repay debt, and produce a clear plan to increase return on equity (ROE). ABC Learning’s ROE fell from 48% to 11% as it expanded overseas – total shareholder return is not the same as ROE because it includes the promise of future returns on equity built into the share price; but sometimes promises are not enough.

The question of margin loans taken out by controlling or major shareholders is vexed.

Arguably, if a change to a substantial shareholding should be disclosed within 48 hours, then a lien against those shares should also be disclosed.

But that would probably make the situation worse. Hedge funds would be provided with a handy list of companies to short, with the aim of triggering margin calls against the controlling shareholders.

But then again, it is clearly price-sensitive information in some circumstances.

If you can short sell the price down to the margin call trigger point, and the shareholder can’t meet the call, then the lender sells it – flooding the market with stock and cascading the price down further, allowing the shorts to cover and profit.

That seems to have been a part of yesterday’s action in ABC Learning; the CEO and major shareholder, Eddy Groves, refused repeatedly on the conference call to say whether he had been margin-called and sold up by his lender, Citibank.

In general, the loophole in the ASX rules that allows short selling based on borrowed stock to be unlimited and undisclosed, unlike normal shorting, encourages more of it than would otherwise take place – and leaves the ASX, again, looking a conflicted and inadequate regulator.

This article first appeared in Business Spectator