[Practical Finance] Caution on Recently Listed Small and Mid-Cap Stocks... Opportunities in 'Cheap Stocks'

Be cautious with newly listed stocks after the short selling ban
Main targets are 'expensive' stocks... 'Cheap stocks' may present opportunities
Pay close attention to changes in leading stocks

From the end of this month, short selling will be fully resumed in the domestic stock market. Since some stocks will see short selling resumed for the first time in up to five years, special caution is required. By carefully considering the existence of individual stock futures products and short selling balances, and selecting potentially undervalued stocks, investors can avoid the aftershocks of short selling and improve their returns.

Be cautious with newly listed stocks... Targets are 'expensive' stocks

Short selling serves to deflate price bubbles in stocks that are overvalued. The main targets are stocks that are 'expensive' relative to their corporate value. Special attention is needed for small and mid-cap stocks or newly listed stocks. Large-cap stocks like Samsung Electronics and Hyundai Motor have already had individual stock futures products and various sector-specific exchange-traded fund (ETF) inverse products, making it effectively possible to bet on price declines.

However, small and mid-cap stocks are an exception. Although short selling was completely banned in the domestic stock market from March 2020 during the COVID-19 pandemic, 350 stocks included in the KOSPI 200 and KOSDAQ 150 indices were allowed short selling from May 2021 until November 5, 2023. Since short selling is being resumed for small and mid-cap stocks after nearly five years, concerns about volatility are greater than ever. Especially, stocks newly listed during the ban period require even more caution.

There are also stocks within the KOSPI 200 and KOSDAQ 150 indices for which short selling is being allowed for the first time. These are stocks newly included in the indices or listed near those dates after the full short selling ban on November 6, 2023. Representative examples include Doosan Robotics (listed October 5, 2023) and L&F (transferred to KOSPI on January 29 last year), which were included in the KOSPI 200 in June last year, and LS Materials, which was listed on December 6, 2023, and included in the KOSDAQ 150 in June last year.

Additionally, stocks with high balances related to short selling, such as margin loan balances and securities lending balances, should be watched carefully. Margin loan balance refers to the amount investors borrow from securities firms to invest, and securities lending balance is the number of shares borrowed for short selling. The higher these balances, the greater the potential for increased volatility when short selling resumes.

'Cheap stocks' may stand out relatively... Could be investment opportunities

While short selling targets expensive stocks, relatively cheap stocks may stand out. At the same time, foreign investors can implement a 'long-short strategy' by simultaneously buying (long) and short selling (short). This could lead to an increase in overall trading volume in the Korean stock market.

Lee Jaewon, a researcher at Hana Securities, explained, "After the short selling ban was lifted in May 2021, the proportion of foreign investors in KOSPI trading volume turned upward, exceeding 30%. Considering that the recent foreign investor proportion in trading volume has fallen to the mid-20% range, foreign influence in the domestic stock market could strengthen after the resumption of short selling."

If foreign influence strengthens, the key will be selecting which stocks to buy. Since the lifting of the short selling ban in May 2021, the gap in stock returns between companies with net foreign buying and net foreign selling has widened. After the resumption of short selling, the average stock return of companies with net foreign buying was 7.1%, while that of companies with net foreign selling was 4.2%. Three months after the resumption, the returns were 8.6% and 1.5%, respectively, further widening the gap.

At that time, foreign investors mainly targeted companies whose foreign ownership ratios had relatively sharply declined during the short selling ban period, but which had large upward revisions in earnings estimates and relatively high return on equity (ROE). They also preferred companies with relatively low price-to-book ratios (PBR). These were companies considered undervalued because their stock prices were low relative to asset value, and earnings were expected to rise further.

In the domestic stock market, for example, HD Hyundai Mipo's foreign ownership ratio dropped from an average of 19.5% since 2022 to about 16.9% at the end of last month. Its expected ROE for this year is 10.5%, more than double the previous year's 4.1%. JYP Entertainment is another company where foreign ownership has decreased, but net profit is expected to rise sharply. Since 2022, the average foreign ownership ratio was 31.0%, but it fell to 25.4% at the end of last month. According to FnGuide, the market consensus for this year's expected net profit is 125.8 billion KRW, estimated to increase by 29.2% compared to the previous year.

Pay attention to changes in leading stocks

Changes in leading stocks that drive the overall market also deserve attention. Even current leading stocks could become targets of short selling if their industry outlook is weak. A financial investment industry official advised, "The secondary battery sector, which once experienced a boom, saw stock prices plunge despite the short selling ban. Ultimately, industry conditions and global trends are more important than whether short selling is allowed."

In the end, corporate performance and industry conditions such as future sales growth rates are crucial. Kim Mingyu, a researcher at KB Securities, diagnosed, "The resumption of short selling is a domestic issue, while leading stocks are determined by global themes. We need to gauge whether leading stocks will maintain their status or fall off by looking at sales growth forecasts for 2025."