Short sellers are increasing bets that cannabis stocks will fall

Rise in short interest comes even as shorts lose money and have to cope with high borrow costs relative to overall market, says S3

Short sellers, or those betting stocks will fall, have steadily increased their exposure to the cannabis sector this year with short interest in the top 20 most shorted stocks climbing 78% to $1.89 billion, according to financial analytics firm S3 Partners.

The increase has come even though short sellers have not had a profitable year with the 20 most shorted stocks garnering $690 million in year-to-date losses, according to Ihor Dusaniwsky, S3’s managing director of predictive analytics.

“The rally we saw in cannabis stocks from late 2017 through 2018 has short sellers jonesing for a price reversal in the sector,” he wrote in a new report published Thursday.

Short sellers take a view on a stock that it will fall in price. They then borrow the shares so they can sell them, hoping they can later scoop them up at a lower price, return them to the original lender and pocket the difference.

The cannabis sector has hit a summer slump following a series of scandals and continued regulatory deadlock. A crop of weaker-than-expected earnings from Canadian licensed producers, the ousting of Bruce Linton from market leader Canopy Growth Corp. and a scandal involving illegal growing at CannTrust Holdings Inc. have weighed on stock prices.

The ETFMG Alternative Harvest ETF MJ, +3.59%  has fallen 24% in the last three months, while the Horizons Marijuana Life Sciences ETF HMMJ, +5.19%  has declined 26%.

At the midyear point, the biggest losers were those who had shorted shares of Canada’s Aurora Cannabis ACB, +7.69% ACB, +6.68%,  who were facing losses of $274 million, according to S3.

Canopy Growth CGC, +4.08% WEED, +3.00%  short sellers were in the red to the tune of $227 million, GW Pharma GWPH, -0.93% short sellers were down $167 million and Cronos Group CRON, +6.13% CRON, +6.14%  short sellers were losing $85 million.

On a brighter note, short sellers of Tilray Inc. TLRY, +4.06%  had profit of $64 million, while short sellers of CannTrust Holdings CTST, +3.67% TRST, +5.92% had profits of $53 million and short sellers of Hexo Corp. HEXO, +5.22%  were looking at gains of $21 million.

Source: S3 Partners

CannTrust shares have plunged 58% in the past month after Health Canada seized more than five metric tons of the company’s cannabis after discovering it was growing in unlicensed rooms.

The selloff intensified after the Globe and Mail uncovered email traffic showing top management was aware of the illegal grow and a Danish partner confirmed that some of the product had been exported. The company pushed out Chief Executive Peter Aceto, and President Eric Paul resigned. A special committee continues to investigate the matter, and on Wednesday, hired Greenhill & Co. Canada Ltd. to help the company explore its strategic options, including a possible sale of the company.

Hexo was in the news this week in reports that it used Snapchat SNAP, +1.74% and Twitter TWTR, +1.69%  to advertise its products, testing Canada’s strict laws on cannabis advertising, which ban targeting young people and teenagers.

Still, the overall weakness in the cannabis sector in July allowed short sellers to recoup more than half their prior year-to-date losses, according to S3.

“The top 20 shorts were up $735 million in mark-to-market profits in July, reducing year-to-date losses to -$690 million,” said Dusaniwsky. “The big winners in July were Canopy Growth (+$301 million), Aurora Cannabis (+$173 million) and Cronos Group (+$82 million).”

Cannabis stocks are expensive to borrow for the purpose of shorting relative to the overall market, he said. “It is 21 times more expensive to borrow stocks in the cannabis sector than in the overall U.S.\Canadian market,” said Dusaniwsky.

The average cost to borrow a cannabis stock in either the U.S. or Canadian market is a 16.75% fee, well above the average 0.80% fee in the broader market. Cannabis short sellers are paying an average of $2.4 million in daily stock borrow costs, “a meaningful offset to alpha gains,” said the analyst.

The most expensive stock borrows are Tilray, which has a small float and comes with a 41.32% fee; Aphria APHA, +40.19% APHA, +38.26%  with a 41.12% fee, Aurora with a 26.12% fee and Canopy with a 25.87% fee.

Those high financing costs and the extreme price volatility in the sector have not acted as a deterrent for shorts.

“Single name short squeezes do not look to be in any of these top 20 stocks’ near-term future,” said Dusaniwsky. “July’s sector price weakness has minimized year-to-date losses and emboldened Cannabis short sellers to continue selling stock.”

The ETFMG Alternative Harvest ETF MJ, +3.92%  has gained 8.5% in 2019, while the Horizons Marijuana Life Sciences ETF HMMJ, +5.19%  has gained 10%.

The S&P 500 SPX, -0.85%  has gained 18% and the Dow Jones Industrial Average DJIA, -0.60%  has gained 14%.

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