One thing I like to keep an eye on as part of my investment research is the list of the most shorted stocks on the London Stock Exchange at shorttracker.co.uk. This list contains the companies that hedge funds are betting against the most.
Now, the hedge funds don’t always get it right. But quite often, they do. Just look at some of the companies that have been shorted heavily by the hedgies in recent years – Carillion, Thomas Cook, Debenhams… all of these companies turned out to be shocking investments.
With that in mind, today I want to warn readers about a well-known FTSE 250 stock that is being heavily shorted right now. Given the high level of short interest, I think investors need to be very careful with this stock.
The FTSE 250 stock I’m referring to is Cineworld (LSE: CINE), the second-largest cinema operator globally.
This is not the first time I’ve warned about the short interest here. Back in early November, when the stock was trading at around 225p, I warned that 10.1% of its shares were being shorted (I see anything above 7% as risky) and that it was the third most shorted stock in the UK. I saw that as “quite concerning.” Today, the shares change hands for around 190p, meaning they’ve fallen 15% since then.
However, the short situation now looks even worse. According to shorttracker.co.uk, Cineworld is currently the second most shorted stock with 13.6% of its shares being shorted. In other words, the hedgies have upped their stake, despite the fact that the share price has fallen recently. That’s not good.
So, what could it be that the hedge funds don’t like here?
Hedge funds smell blood
Well for starters, the group issued a disappointing trading update in December. Describing the backdrop as “challenging”, the company reported a 9.7% decline in total revenue (and a 12.8% decline in box office revenue) for the period 1 January 2019 to 1 December. It also advised that revenue for the full year is expected to be slightly below the company’s expectations.
Growing debt pile
Second, Cineworld recently announced the acquisition of Canada’s Cineplex for $2.1bn. Now, the FTSE 250 company already had a large chunk of debt on its balance sheet. Recent half-year results showed a net debt-to-adjusted EBITDA ratio (a measure of a company’s ability to pay off its debt) of 3.3 times, which is high. This acquisition, which will be debt-funded, will further increase its leverage. That’s not ideal, particularly when you consider that we are late in the economic cycle. A high level of debt means the company could be extremely vulnerable in the event of a recession.
Finally, there’s the competition that cinema operators face from Netflix. I see this as a significant long-term threat. Given that a basic monthly subscription to Netflix costs less than £10 (which gets you access to an incredible range of TV shows and movies) versus around £25 to £30 for two movie tickets, the outlook for cinema operators looks challenging, to my mind.
Cineworld shares do look cheap at the moment. Currently, the forward-looking P/E ratio is just eight. However, given the high level of short interest, I think the most sensible move is to steer clear.
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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Netflix. 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.