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The Globe and Mail

Rocky Mountain Dealerships: Why I own the stock despite the short sellers

Fabrice Taylor, CFA, publishes the President's Club investment letter. His letter and The Globe and Mail have a distribution agreement.

There's an interesting battle brewing at Rocky Mountain Dealerships Inc., and if you back the right side, you could be handsomely rewarded.

In one corner, are management and other insiders who have been scooping up the company's shares as they've weakened. Chief executive Matt Campbell personally bought $1-million worth in May at around the current price. Big funds that own more than 10 per cent have also added to their positions, as has the chief financial officer. The company raised its dividend 15 per cent a few weeks ago.

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These are normally bullish signs, but they're not convincing skeptics who have sold short 1.3 million shares, which is about 15 per cent of the float.

Given current trading volumes, it would take more than two months to buy back that stock, assuming the short sellers were the only ones buying. They wouldn't be, of course, which means that if the shorts want to cover their position with any haste, they'd have to be aggressive buyers, and that would drive the stock price sharply higher.

It's not clear to me, or to Mr. Campbell, who the short sellers are. A company whose stock is yielding more than 4 per cent and that has no obvious problems is an odd one to bet against (the short seller has to pay the dividend to whomever he borrowed the stock from). That's especially true once you consider that the company's insiders are vacuuming up shares in the open market and that the board approved a higher dividend, which is a sign of confidence.

The only thing I can think of is a pair trade, whereby a fund sells short one stock and uses the proceeds to buy shares in another, somehow-related industry. That way the fund earns a return if the stock it owns does better than the stock it sells short. Even if both go up – or down – it only matters that the long stock does better than the one sold short. The only company I can imagine being the long part of the trade is Cervus Equipment Corp.

While a plausible thesis, it also doesn't make much sense. Cervus has advantages, to be sure. Like Rocky Mountain, it owns dealerships that sell equipment to construction contractors and to farmers. Cervus's brands include John Deere and Bobcat, while Rocky is largely a Case distributor.

Deere in particular is an excellent brand, partly because the company started to develop its dealership base 40 years ago and infused a mission of profitability into its dealer network. Case has not done so, so when Rocky Mountain acquires the dealers, they are not as profitable as they should be. But I find that attractive, because it suggests room for improvement over time. Even an extra percentage point or two of gross profit would make a huge difference for Rocky Mountain shareholders.

A bigger concern for Cervus shareholders, though, is the Canada Revenue Agency. The CRA is challenging Cervus's conversion into a corporation from a limited partnership. There are a number of these challenges unfolding now, and I'd rather not bet against a government that's running deficits and looking for cash. Cervus is a fine company, but the potential damage could be tough on the company's balance sheet, although it could take months and months to wend its way through the system.

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I prefer Rocky Mountain, which has the room to improve margins and increase its dividend. The insiders think the stock is cheap enough to load up on. The construction side of the business is thriving and while the agriculture segment is softer because farmers have spent a lot of money on equipment in recent years, it will bounce back.

So to me, investing at current prices, which I have done, pays you to wait for improving margins, stronger farm sales and for the day short sellers start to cover, which will create enormous demand for the stock. I can easily see a very healthy double-digit return, and I'm happy to collect my dividends along with insiders until that happens.

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