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The prolonged bull market that followed the stock market crash of 2008 was brutal for short sellers. But the tide appears to be turning for them now that runaway inflation is pushing central banks to hike interest rates and cool off the economy.

Investors who simply go long stocks thus may want to avoid companies in short-sellers’ sights even more so at this point. It could also be one of the better times to hedge long positions with short positions in specific stocks or in market-level exchange-traded funds such as SPDR S&P 500 Trust (SPY) and iShares S&P/TSX 60 (XIU).

Many professional short sellers disclose their open positions in media interviews and/or on their websites – often with in-depth research reports available at no charge. Such stocks could be candidates for investors to avoid, or even to sell short themselves for the purpose of hedging a portfolio. (Short sellers sell stocks they have borrowed, hoping to make a profit buying them back at a lower price before returning the borrowed shares.)

But when riding the coattails of seasoned short sellers, investors may want to consider screening out stocks that are down more than 30 per cent over the previous month to avoid shorting extremely oversold situations. Also consider excluding stocks with low trading volumes, prices under $2 and high borrowing costs.

Here are six candidates worth a look:

KE Holdings Inc. (BEKE-Q)

One of the more successful of short sellers over the past decade is Carson Block, founder of hedge fund Muddy Waters Capital. Just before 2022, he went short the U.S listing of KE Holdings Inc., a Chinese real estate company operating an online and offline platform for property transactions in Shanghai and Beijing. Muddy Waters conducted a series of site visits, field interviews and data checks and that led Mr. Block to allege that KE Holdings had inflated its real estate transactions and revenues. In response, the company declared the short seller’s “report is without merit and contains numerous errors of fact … and shows a lack of basic understanding of the housing transactions industry in China.”

Natera Inc. (NTRA-Q)

Nate Anderson is the founder of Hindenburg Research, the firm that caught Nikola Corp. misrepresenting the speed of its EV trucks by rolling them downhill. In March, Hindenburg issued a sell recommendation on Natera Inc., a genetic testing company with a core business in non-invasive prenatal testing. After interviewing more than two-dozen former Natera employees, patients and experts, and reviewing online complaints and freedom of information requests to Medicaid offices, Hindenburg alleged that revenue growth was fuelled by deceptive sales and billing practices. The company responded: “We disagree with the accuracy of this report which was generated in an attempt to make a quick profit by short sellers …. In 2021, we performed over 1.5 million tests and … we’re proud to have an A+ rating with [the Better Business Bureau].”

Standard Lithium Ltd. (SLI-Q)

Mr. Anderson is also short Vancouver-based Standard Lithium, which is testing the commercial viability of lithium extraction at its flagship property in Arkansas. Another short seller of this stock is Blue Orca Capital LLC, founded by Soren Aandahl. Its short-sale thesis postulates that Standard Lithium has spent little on research and development while spending a lot on stock promotion. The company called the short-seller reports “false and misleading” and urged “investors to … instead consult credible and informed sources, including Standard Lithium’s filings with the Canadian regulatory authorities ….”

Innovative Industrial Properties (IIPR-N)

Blue Orca Capital is also short Innovative Industrial Properties Inc. Mr. Aandahl claims IIPR appears to be a real estate investment trust but, in effect, it lends to U.S. cannabis companies (which face problems getting loans from many U.S. banks) by purchasing properties from them at above-market prices and then leasing them back at elevated yields. In the opinion of Mr. Aandahl, the cannabis sector has become highly competitive and some IIPR clients are financially distressed. The company rebutted the short seller’s view, asserting it “contains numerous false and misleading statements … and demonstrates a basic lack of understanding of commercial real estate generally [and] the regulated cannabis industry ….”

Li-Cycle Holdings Corp. (LICY-N)

Mr. Aandahl is short yet another company: Toronto-based Li-Cycle Holdings, which is involved in recycling lithium-ion batteries and went public recently through a special purpose acquisition company. It trades at a high ratio of share price to trailing revenues, notes Mr. Aandahl, who believes the accounting has overstated revenues and he adds that the chief financial officer and auditor recently resigned. In response to an e-mailed query from The Globe and Mail, a company spokesperson replied: “This report contains numerous inaccuracies and mischaracterizations …. Given the importance of our mission, we’re staying focused on continuing to grow with rapidly surging demand, to serve our customers and stakeholders, and drive value for our shareholders.”

Coinbase Global Inc. (COIN-Q)

Jim Chanos is president and founder of Kynikos Associates, one of the oldest short-selling firms, founded in 1985. Mr. Chanos is short Coinbase Global Inc., the only cryptocurrency exchange of significance listed for trading on a U.S. stock exchange. Coinbase’s shares have become a favourite with retail investors, to the point where it could even be categorized as a meme stock with a rich valuation. Mr. Chanos sees competition in Coinbase’s market niche intensifying, which he says will likely compress its margins and lead to weakness in upcoming earnings reports.

Online brokerages have made it easy for investors to short stocks with a few clicks of the mouse in accounts set up for short sales – although many brokers may not allow shorting of certain stocks (those priced under $2, for example). Also, bear in mind the pitfalls:

  • If the stock rises, there may be margin calls. If not paid, the position will be closed;
  • Potential losses could exceed deposited capital if the price of a stock suddenly soars;
  • The cost to borrow shares could climb during a trade and erode returns;
  • Stocks that delist can tie up capital for periods of time;
  • The few brokers that allow shorting of low-priced stocks usually charge hefty fees.

These pitfalls are less of a concern if diversified ETFs such as SPDR S&P 500 Trust and iShares S&P/TSX 60 are shorted instead (although the potential returns may not be as great as the riskier trade of shorting individual stocks).

Special to The Globe and Mail

Larry MacDonald also writes at Investing Journey (https://larrymacdon.substack.com/archive)

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