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Short sellers borrow shares from brokers and sell them on the stock market.

If the price of the shares subsequently fall, short sellers can make a profit by buying the shares at the lower price and returning them to the lender.

Academic studies have shown that short selling activity has a good record in pointing out fraud, overvaluation and poor company fundamentals – thus often foreshadowing weakness in share prices. An exception is short selling undertaken not to bet on falling prices but to arbitrage price discrepancies between stocks and convertible securities, as appears to be the case for companies like Quebecor Inc.

Table I shows the 10 companies on the Toronto Stock Exchange (TSX) with the highest percentage of shares on loan, as of Dec. 12. Not much has changed. Nearly all of the companies were on last month's top-10 list (which can be found here). The only new entry is Labrador Iron Ore Royalty Corp., with 12.3 per cent of its shares on loan.

Two years ago, 25 per cent of the company's shares had been borrowed by short sellers, as iron ore prices tumbled in response to a contraction in Chinese manufacturing. This year, Chinese manufacturing is again slowing down, as highlighted by a dip in IHS Markit's China Manufacturing Purchasing Managers Index to a 5-month low last month.

But it's not yet time to panic. This latest reading and current prices for iron ore are far better than two years ago.

TSX stocks with the highest percentage of shares on loan (as of Dec. 12)

Sector% of Shares Short
Quebecor Inc.QBR.B-TMedia30.0%
Badger Daylighting Ltd.BAD-TCapital Goods25.0%
DHX Media Ltd.DHX.B-TMedia20.5%
Boardwalk REITBEI.UN-TReal Estate18.7%
Klondex Mines Ltd.KDX-TMaterials16.4%
Canadian Western BankCWB-TBanks15.6%
First Majestic Silver Corp.FR-TMaterials14.7%
Ritchie Bros. Auctioneers Inc.RBA-TBusiness Services13.3%
Labrador Iron Ore Royalty Corp.LIF-TMaterials12.3%
AGT Food And Ingredients Inc.AGT-TFood & Beverage12.1%

Source: IHS Markit

Table II presents the top 20 Canadian companies (on the TSX and Venture Exchange) in terms of the cost to borrow shares.

Many companies don't have a lot of shares available for lending, so short sellers cannot borrow a large number. For these companies, the percentage of shares sold short will not be a good measure of bearish sentiment. A better indication would be how high short sellers have bid up the cost to borrow the limited number of shares available for borrowing.

The table reveals the extent to which the short crowd are giving the thumbs down to marijuana stocks. Nearly half of the entries are from this sector.

These companies are in the early stages of development with little in the way of revenues or earnings, yet their shares prices have soared in 2017 on expectations of substantial growth occurring after recreational sales of marijuana becomes legal in Canada this July.

The short sellers' bearishness hints at overvaluation in the sector and a looming correction in stock prices.

Independent investor Sacha Peter is not one of the short sellers, but he, nonetheless, presents a bearish viewpoint on his blog.

As it appears marijuana is to be distributed in a manner similar to liquor, he argues that provincial governments will "keep the lion's share of the profit" by virtue of their monopoly on the wholesaling of marijuana to small retailers. Mr. Peter also believes "retail marijuana profitability will be worse than liquor because people can easily grow their own product [Federal legislation allows people to grow certain amounts of marijuana at home]."

But this does not necessarily mean a correction is imminent.

Short sellers are often correct in their theses but too early in taking positions. Indeed, before the euphoria dies down, there could be further gains in price – fuelled in part by the weaker short sellers deciding not to ante up for margin calls and instead unwinding their bets (by buying shares and returning them to the lenders).

Canadian companies with the highest cost to borrow (as of Dec. 11)

Company SectorCost to borrow (annual %)
Acasti Pharma Inc.ACST-XPharma41.8%
Horizons Marijuana Life Sciences ETFHMMJ-TMarijuana38.0%
Cannabis Wheaton Income Corp.CBW-XMarijuana36.9%
Street Capital Group Inc.SCB-TMortgages35.3%
Invictus MD Strategies Corp. IMH-XMarijuana32.9%
Emerald Health Therapeutics Inc.EMH-XMarijuana31.7%
MedReleaf Corp. LEAF-TMarijuana30.0%
Titan Medical Inc.TMD-TTechnology28.3%
MCAN Mortgage Corp.MKP-TMortgages28.2%
Garibaldi Resources Corp.GGI-XMining27.3%
Exchange Income Corp EIF-TAerospace27.2%
Redknee Solutions Inc.RKN-TSoftware26.3%
Canopy Growth Corp.WEED-TMarijuana26.3%
Aurora Cannabis Inc.ACB-TMarijuana25.1%
Novo Resources Corp. NVO-XMining24.4%
Cronos Group Inc.MJN-XMarijuana23.9%
Imperial Metals Corp. III-TMining21.5%
Aphria Inc. APH-TMarijuana21.4%
Equitable Group Inc. EQB-TMortgages20.7%
Northern Dynasty Minerals Ltd.NDM-TMining19.9%

Source: Interactive Brokers

While the level of short interest in a stock may not be all that informative unless it is related to a benchmark in some way (for example, the number of shares trading), the change in short interest over time can be useful to track. It can tell us something about the short sellers' frame of mind, whether or not it is becoming more bearish or less so.

Table III lists the top-ten Canadian companies experiencing large percentage increases in the dollar value of short positions during the month to Dec. 12 (excluding companies with less than a $10-million change in short position).

Consistent with Table II, a number of marijuana stocks appear on Table III.

The Stars Group Inc., once known as Amaya Inc., offers real and simulated online gambling though games such as poker. Company founder David Baazov faces an insider trading trial later this month. Recent court filings by the Quebec securities regulator also allege that Mr. Baazov and two associates conspired to prop up the shares of his company prior to acquiring another company.

Top 10 increases in short interest during month ending Dec. 12

Company Sector% increase in dollar value of short position
H&R REITHR.UN-TReal Estate893.1%
Emerald Health Therapeutics Inc.EMH-XMarijuana420.6%
OrganiGram Holdings Inc.OGI-XMarijuana323.3%
Parex Resources Inc PXT-TOil & Gas237.6%
Intact Financial Corp.IFC-TInsurance158.3%
EnerCare Inc.ECI-THome Services154.1%
Medreleaf Corp.LEAF-XMarijuana144.9%
Klondex Mines Ltd.KDX-TMining123.6%
Canadian REIT REF.U-TReal Estate112.8%
Stars Group Inc.TSGI-TGambling105.6%

Source: S3 Partners

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