Seeking Alpha

Playing House: An Aggressive 40%+ Yielding Securities Lending Strategy

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Includes: ABIO, AMRH, ANY, APRN, CPAH, DTEA, ELTK, FHL, GLG, HBANN, IPDN, MARA, MYT, NH, OBLN, OGEN, OTLK, STAF, TVC, VLTC, VVPR, WORX
by: Harrison Schwartz
Summary

Securities lending allows investors extra income by lending their shares to short sellers for a borrowing fee.

Stocks with high borrowing fees are typically expected to go bankrupt or decline in value by short sellers.

By looking at the stocks with the highest borrowing fees (typically above 80% annually), we can create an index of stocks with poor financial prospects and low market capitalization.

By creating an equal-weighted portfolio of these stocks, we can theoretically gain a 47% annualized yield from lending income but with likely negative principal returns.

In a time of ultra-low interest rates investors are likely to become interested in "alternative yield" strategies like this.

(Source - Pexels)

An increasing number of brokerages are allowing individual investors to take part in lending their long positions to short sellers for extra returns from short sellers ' interest payments. This is also known as a "Stock Yield Enhancement Program" or SYEP. In the case of Interactive Brokers, investors receive half of the total fee received by the brokerage (the other half goes to Interactive Brokers).

While that brings in little for the majority of stocks that have fee rates less than 1%, some stocks have such poor availability or extremely high short-seller interest that these rates are as high as 99%. Clearly, lending in-demand securities could make for a profitable income-generating strategy if done correctly.

It is worth noting the downsides of securities lending. First, lending rates can vary dramatically over time, so yield received is not necessarily stable. Second, investors lose their voting rights when they lend their shares. And third, lent shares may not be protected by SPIC. On a positive note, dividends will still be received and market exposure is unchanged, investors can sell whenever they like, and covered calls can still be sold against the shares. Unless circumstances are extreme, an investor is unlikely to be negatively affected by lending their shares.

I ran across an interesting website the other day called iborrowdesk that allows anyone to easily look up stock borrowing fees and see which stocks have the highest rates. High borrowing fees are a sign that brokerages lack the shares available to lend to short sellers. It also implies that investors are extremely bearish on the given stock. Importantly, I cross-referenced the site with my own brokerage and found that the website is giving accurate data.

I complied a list of the top 22 highest borrowing fee companies in the United States to see firstly why short sellers are so bearish (i.e., financial red flags) and secondly if a high yielding low-risk strategy could be created by creating a portfolio of them and lending the shares.

Here is the list and current borrowing fee, past return, and share price for each:

Ticker Name Market Cap Borrow Fee Est. Lending Return (50% Borrow Fee) Past Year Return Current Share Price
(MARA) Marathon Patent Group, Inc. $11,302,167 89% 44% -76% $ 0.58
(CPAH) CounterPath Corporation $7,743,874 89% 44% -98% $ 0.37
(APRN) Blue Apron Holdings, Inc. $92,676,536 91% 45% -5% $ 3.40
(AMRH) AMERI Holdings, Inc. $11,780,622 91% 45% -60% $ 0.31
(FHL) Futu Holdings Ltd $903,149,952 91% 45% 1% $ 3.79
(OTLK) Outlook Therapeutics, Inc. $19,320,192 90% 45% -49% $ 1.47
(VVPR) VivoPower International PLC $18,166,858 92% 46% 5% $ 26.99
(STAF) Staffing 360 Solutions, Inc. $11,421,780 92% 46% -35% $ 1.45
(OBLN) Obalon Therapeutics, Inc. $5,939,943 94% 47% -50% $ 1.60
(ABIO) ARCA biopharma, Inc. $7,393,042 94% 47% -6% $ 0.85
(OGEN) Oragenics, Inc. $20,958,042 95% 47% 10% $ 26.67
(TVC) Tennessee Valley Authority $291,660,384 95% 47% -7% $ 0.40
(OTC:VLTC) Voltari Corporation $7,645,592 96% 48% -52% $ 5.35
(IPDN) Professional Diversity Network, Inc. $7,105,998 90% 45% -88% $ 2.22
(ANY) Sphere 3D Corp. $2,929,933 97% 48% -26% $ 1.40
(HBANN) Huntington Bancshares $29,429,999,616 98% 49% -9% $ 1.34
(DTEA) DAVIDsTEA Inc. $37,728,412 98% 49% -72% $ 1.83
(ELTK) Eltek Ltd. $7,566,499 98% 49% -27% $ 11.20
(WORX) SCWorx Corp. $24,715,766 99% 49% -84% $ 0.26
(MYT) Urban Tea, Inc. $3,806,108 99% 49% -79% $ 7.13
(GLG) Bat Group, Inc. $2,711,050 100% 50% -38% $ 1.25
(NH) NantHealth, Inc. $61,546,428 100% 50% -52% $ 1.66
Effective Dividend 47%

(Source - IBorrowDesk)

So, if you owned these companies on an equal-weighted basis and lent those shares you are expected to receive an extremely high expected yield of 47%.

Of course, when something seems too good to be true it is usually true. If you look at the market capitalization of these companies you will see that almost all have capitalization far below the requirements of most investors. Bat Group, for example, is a Chinese ADR with a market capitalization of $2.7M and has no coverage on Seeking Alpha. Most of the stocks have low volume, are nearly bankrupt, trade at less than $5 per share, and lack transparent information/investment media coverage. While a 47% income yield is attractive, free lunches are few and far between.

Since 2016 these stocks have declined at an average of 50.1% per year. Of course, they have high short interest fees because they've been falling so much, so that is not to say they will continue to decline at that rate. Still, this "Hard to Borrow" index chart is interesting:

(Price Data Source - Google Finance)

Note, this is the performance of an equal-weighted portfolio of the above 22 stocks over the past three years rebalanced daily.

Clearly, these basket companies have been among the worst investments on the market today. That said, if you happen to manage a small amount of money and are looking for aggressive yield, this may still be a possible strategy. As I said earlier, by looking at stocks with high short interest, one is likely guaranteed to find primarily stocks with negative past performance.

The question then is, how bad should we expect these stocks to perform going forward? If the answer is greater than negative 47% per year (the amount expected to be earned through securities lending), then we may have found a profitable strategy that is largely unknown by most individual investors.

A Fundamentally Dire Situation

Admittedly, it is very difficult to analyze the financial situation of these companies. Of the 22, only three made a profit last year. Many have negative owners' equity, high debt, and may go out of business soon. Take a look at some select fundamental information on them:

Note: "Typical" denotes the column's median value. Blank values indicate no or negative data. Color scheme does not represent good or bad absolutely, but relative to others.

(Source - Unclestock)

No reason to downplay it, this is one of the most alarming sets of financial information I have seen. To begin, the median company lost money equal to its entire market capitalization last year. The median company also has less liquid assets on hand for current liabilities (current account less than one) and has poor solvency at a median debt to assets of 74%. This statistic is not shown above, but the Altman Z-Score for all of the companies was below one which indicates high bankruptcy chances.

On a slightly positive note, the median company is trading at a 30% "P/S" discount based on five-year historical averages, and is likely trading near book value if book value is positive. However, I think it would be wise to not place much trust in the recorded book value of these companies because it is likely not equal to its market value.

Overall, it seems that these companies have low prospects. That said, I expect these companies to fall less than our 47% minimum over the next year. For example, Blue Apron has been in near-constant decline since its IPO, but has seen improved gross margins in recent quarters and may surprise investors to the upside. I personally would not normally buy Blue Apron, but for a 45% yield, it could certainly be worth it.

The Bottom Line

Securities lending programs are becoming more popular and I expect them to become available in most brokerages over the coming years. It is a great deal for brokers as they get to keep half of the fee income (without principal risk), and a great deal for long-term investors looking to boost their yield. It seems smart for investors to keep track of stock borrowing fees and possibly use the information for gauging perceived risks by the broader investment community.

Regarding the top 20 hardest-to-borrow companies, only time will tell if they will slow their fall. Frankly, I would be surprised if even ten of the companies still exist five years from now, but I still think owning and lending them may be profitable given their extremely high borrowing fee returns.

Cognitive biases usually push short sellers to bet heavily against companies that have declined in value, with the expectation that those declines will continue. This pushes up borrowing costs to the advantage of long investors who are willing and able to lend their shares.

This situation can also create a very high short-squeeze risk where borrowing costs reach a level where short sellers can no longer make a profit and all must close their position at the same time. This buying pressure can overwhelm the market and has been known to cause stocks to rise 20-100%+ in a matter of days or hours. That is not to say this will happen to the entire "Hard-to-Borrow" basket, but it could occur for some of those stocks.

I have no plans to pursue this particular strategy until I can test it live. I'll be keeping a close eye on this basket to see if the companies decline at a lower rate than their securities lending returns. Feel free to give us a "Follow" if you would like to see this update.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.