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I’d be extremely careful with this FTSE 250 stock. Hedge funds are shorting it heavily

If a stock is being heavily ‘shorted’, it pays to be careful. It means hedge funds and other sophisticated investors have seen something they don’t like and are betting the stock will fall.

Shorters don’t always get it right, of course, but quite often they do. Just look at the list of UK companies that have been heavily shorted by hedge funds in recent years – Carillion, Debenhams, Thomas Cook… we all know what happened to these stocks.

With that in mind, I want to highlight a FTSE 250 stock that’s being shorted heavily at present so I think investors need to approach this stock with caution.

Cineworld

The company is Cineworld (LSE: CINE), the second-largest cinema business in the world. According to data from shorttracker.co.uk, it’s currently the third-most-shorted stock on the London Stock Exchange, with short interest of a high 10.1% (this means 10.1% of its shares are being shorted), up from around 7.2% in late August. At present, there are 10 different institutions shorting it.

I see this high level of negative interest quite concerning. In my view, short interest over 7% or so is a red flag. In Cineworld’s case, the hedgies clearly see something they don’t like and expect the shares to fall. So, what could be the problem here?

Balance sheet issues

One issue to be aware of in relation to Cineworld is the group’s balance sheet. In late 2017, the group struck a deal to acquire US cinema group Regal Entertainment for nearly $6bn and this added a considerable chunk of debt to its books.

Recent half-year results showed adjusted net debt stood at $3.3bn, which equated to an adjusted net debt to adjusted EBITDA ratio (a measure of a company’s ability to pay off its debt) of 3.3 times. That’s quite a high ratio, which suggests the company could be vulnerable if profits were to decline.

It’s also worth noting the company has a huge amount of goodwill ($5.5bn versus equity of $3.3bn at 30 June) on its balance sheet. This could potentially lead to write-downs in the future.

Poor results

Half-year results, issued on 8 August, were also a little concerning. Blaming the timing of major film releases, the group reported a 14.4% fall in admissions, an 11.1% drop in revenue, and an 11.8% decline in adjusted EBITDA.

I would expect second-half results to be better, due to the popularity of films such as Joker and The Lion King, but this is also something to keep an eye on. 

Approach with caution

Whatever the specific issue the hedge funds have identified, I think caution is warranted towards Cineworld shares right now. Whereas the market is filled with ‘weak’ longs (investors who hold a stock because it’s part of the index or because everyone else owns it), you rarely find a weak short, because shorters face unlimited losses if they’re wrong.

Cineworld’s current high level of short interest indicates hedge funds believe there’s something fundamentally wrong with the company.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.