Both Tilray Inc (TLRY US) and Aphria Inc (APHA US) were mentioned as attractive short plays at Whitney Tilson’s recent conference. Chris Brown of Aristides Capital LLC maintains that cannabis is in actuality a commodity business and therefore most cannabis related stocks are overvalued, and in the case of TLRY overvalued by over 40%. Fabriel Grego of Quintissential Capital expects “massive” asset write-offs at Aphria relating to South American company acquisitions which are “largely worthless.”
While hedge funds and asset managers are looking at the cannabis sector for short ideas, tobacco and distilling companies are looking at the sector for acquisitions. The Financial Times reported that Altria Group Inc (MO US) is exploring acquisitions in the cannabis sector, looking specifically at Cronos Group (CRON US). This follows Constellation Brands (STZ US) acquiring a stake in Canopy Growth.
Stocks in the Cannabis Sector were down 5.21% today, with shorts up $157 million in mark-to-market profits. The big short side winners were Canopy Growth Corp (CGC US), Aurora Cannabis Inc (ACB US), Tilray Inc (TLRY US) and Aphria Inc (APHA US). The only major cannabis stocks up for the day were GW Pharma (GWPH US) and Cronos Group Inc (CRON US).
Short selling in the Cannabis sector is extraordinarily concentrated with 93% of all shares shorted in the top six most shorted companies in the sector. Short sellers are predominately shorting the larger cap companies in the sector with the most trading liquidity. Unfortunately, the higher capitalization and breadth of long shareholders has not translated into liquidity in the stock loan marketplace. With many institutional asset managers, both hedge fund and long only, precluded from investing in Sin Stocks (alcohol, tobacco, firearms, recreational drugs, etc.) many of the largest stock lenders do not have these stocks in their lendable inventory. This has made the Cannabis Sector the most expensive sector to borrow stock in support of short sales.
In addition to high stock borrow rates, with financing expenses hitting $2 million per day, there is also a high level of recall risk in these expensive borrows. Stocks like TLRY will normally have 50k – 100k shares of recalls hitting the street on a daily basis, forcing brokers and prime brokers to scour the street for replacement shares at ever higher borrow rates. And if replacement stock borrows are not found, shorts are forced to liquidate part of short positions to satisfy the recalls.
Shorting the Cannabis Sector has not been a home run trade in 2018 with an average negative return of -1.17%, but the price run-up that occurred in the latter half of 2018 has made it an attractive target for both value and momentum short side traders. While the “reversion to the mean” thesis may eventually hold true, the interim will be filled with volatile price spikes, expensive short financing expenses, stock borrow recalls and potential short squeezes.
We should continue to see incremental short selling in the sector in securities that have stock loan availability as actual acquisitions and rumors of acquisitions drive up the price of many stocks in the sector and make them even more attractive to short sellers. If more institutional shareholders take on long positions in the sector, stock borrow availability should increase and stock borrow rates should ease. But in the meantime, Cannabis Sector short selling is an expensive and volatile proposition. While the sector may be relaxing for the companies’ customer base it is most certainly not relaxing for the sector’s short side traders.
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Managing Director Predictive Analytics, S3 Partners, LLC
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