How To Play Silvercorp Now That The Short Sellers Are Covering

Sep.26.11 | About: Silvercorp Metals (SVM)

This is the third article in my Silvercorp Metals (NYSE:SVM) trading saga. While it looks like I'm flip-flopping on my decisions, that's true, but it's only based on the change of information in front of me. Being a trader, I often look for uncertain stocks in new situations because that's where the market can be played the best - if you're one step ahead.

There are many different factors I look for in finding these "uncertain stocks" and Silvercorp has a lot of them. High short interest, majority of business in China, conflicting reports between shorts and longs, high growth potential, high fraud potential, volatile industry, and easily affected by news.

On Friday, September 23rd, I completely covered my short position. I did it because the stock wasn't dropping as I expected it would. Also, surprisingly, the Al Little (AL) organization covered all of its short interest.

On Thursday, September 22, morning, things were going great for SVM shorts. SLV, the silver ETF, kept going lower and was down 7% in the morning. All the gold and silver miners were getting crushed, including SVM, many by between 7-10%. I was waiting for SVM to go below $6.50 a share as that was my target to cover part of my short position. It had almost gotten there, it was down to the low $6.60s. Then I looked away for a little while, and when I looked up at around noon, Silvercorp was only down 1%. I couldn't believe my eyes! At one point SVM was actually in the green while SLV was down 8%.

Here is the chart of SVM last week.

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Click to enlarge

Here is SVM vs SLV for the week.

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I started searching the internet for news on SVM, as its price wasn't correlating with SLV like it should have been. Something material must have happened for this to occur, it couldn't have happened on its own. Then when I looked at a new letter from Alfred Little in my inbox, I had found the answer to SVM's strange bounce.

AL had sent a letter to subscribers showing how through their studies, the purity of Silvercorp's ore is much less than was stated by the company.

Towards the bottom of the letter was a disclosure stating:

Due to a lack of ability to borrow SVM shares to sell short, contributors to today's report currently have no position in SVM but may initiate new positions at any time.

This letter was received at 11:46 AM on Thursday, September 22. Looking at the daily chart, within three minutes of the letter sent SVM had popped up 6%, from $6.65 to $7.05. It's pretty easy to deduce what happened. Big hedge funds who follow Alfred Little and are short SVM saw that the "Chinese fraud expert" covered, so they did too. As millions of short shares got furiously covered, the stock bounced significantly.

As I'm not one to trade on my emotions, I took this as an opportunity to short even more SVM shares. This was obviously a black swan event. Once investors see that SVM is the only silver miner in the green while silver is getting pummeled so badly, then they are going to sell and the stock is bound to drift back down into the red. Sure enough, this is what happened, and I was able to make a quick profit as I covered the shares traded for this reason, but I still kept my core short position.

This email by AL irritated me of course, and I brought it up with Simon Moore, Alfred Little's managing editor. I sent him a letter sarcastically saying: "Thanks for announcing that you covered your short position."

Now, I've spoken with Simon before and we have been exchanging emails regarding SVM and other Chinese stocks. He has given me some good information regarding the fraud exposure business. I think the Alfred Little organization is doing society a favor by exposing Chinese frauds, or at least reporting facts that could be interpreted as fraud.

AL has their own reasons for their investment decisions, and I'm not going to go into that here, nor am I blaming them for covering their short position. They, like everyone else, are free to do what they want with their money. But whatever their reason is for covering their short, in my opinion it's a clear sign that they don't think SVM is going to go down much in the near future.

SinoTech Energy Limited (NASDAQ:CTE) was a Chinese fraud busted wide open by AL. On August 16, AL put out its first report on CTE. AL's allegations of fraud were so obvious and easy to prove that the NASDAQ halted trading of CTE within a day or two. After a stock is halted, investors can't short any shares until trading is allowed again, in which case the stock usually would plummet 50% or more. With Silvercorp, if there is fraud, it certainly isn't the most obvious case.

On Interactive Brokers alone, there are currently 500,000 SVM shares available to short, and the borrowing fee is about 12%/year. Although the borrowing fee is higher than most stocks, a 1% a month fee is a small price to pay compared to gains made if the stock will be halted or plummet. Therefore, it's clear that the information that AL has on Silvercorp isn't enough to make SVM plummet in the next couple months, or this is what AL believes anyways.

SVM has been holding up very well from the massive silver pullback. This is because its movements have been taken over by the fraud allegations (or the disproving of them) and the investors who still like the company. The story of whether it's a fraud or not affects SVM a lot more than the movements of silver does. This is why it hasn't gone down as much as the other miners. Those shorting the stock now due to the fraud allegations are late for the party, myself incuded. AL's short exit may be a signal that the shorting party is coming to an end. SVM has been drifting lower from the short interest and possibilities of fraud for awhile now, from $10 a share on down to where it is now. The stock started drifting down even before the recent specific fraud allegations simply because it's a Chinese company trading on a Canadian exchange in a historically shady industry.

How To Play SVM From Here

For now, I believe the best play is to stay on the sidelines and pay attention. Silvercorp seems to have a core group of longs that are committed to holding their investment unless silver plummets more. Watch the price of silver. As silver continues to go down, some longs will sell. Watch the short interest. I expect more and more hedge funds to start covering their short positions in the coming weeks. At this point, shorts seem to be less confident in the short thesis than longs are in the value thesis.

However, if SVM rises in share price, this sentiment can flip. If silver makes a rebound soon, it may be a good idea to take a long position in SVM as the shorts cover. Once the short interest decreases, then selling your SVM long position will complete the short term trade. I personally would only make short term trades in SVM, as I am uncertain about both the long term fraud and long term value points of views.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.