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  • Writer's pictureTed Ohashi

What we can learn from Constellation's investment in CGC

When monumental events such as the second investment by Constellation Brands (NYSE: STZ) into Canopy Growth (NYSE: CGC) provides a number of learning opportunities. One is certainly what short selling is and how it effects a company’s stock price and, in the case of Constellation/Canopy, the effect it can have on many other related companies such as Aphria and Aurora.

What we explain below is the basic “short sale” transaction. There are some investment and trading strategies that involve options and short selling as a package. We are not going to discuss these sometimes esoteric trading strategies. These are for the highly sophisticated investor.

One of the oldest investment adages is “buy low, sell high.” Of course the person who first coined this axiom should have added “but not necessarily in that order.” What I mean by that is as long as you buy low and sell high, you will profit whether you bought first or sold first.

With most investments, it is hard to sell first because oil paintings and different plots of real estate are unique. But in the case of stocks, in normal circumstances, each common share of a company is exactly the same as any other common share of the same company. So I can sell 100 shares of Canopy Growth even though I don’t own them. Later on I can buy them and if it is at a lower price then I will have profited. I bought low and sold high, the only difference being I sold first and bought later. This is called a short trade. The more normal transaction where you buy first is called a long trade and it creates a long position.

The initial sale transaction of the borrowed security is called a “short sale” while the transaction to buy back the shares previous shares sold short is called the “closing trade” because it closes out the investor’s position. In a long trade, the closing transaction is a sell and for a short sale, the closing transaction is a buy.

The motivation for the typical investor who buys long (buys first and sells later) is the expectation that the stock will rise in price. But the short seller believes the stock is overpriced and projects it will decline in price. So the basic reason for shorting is the exact opposite reason most people invest which raises another point. People who buy speculative penny stocks and see them go down a lot often joke sardonically, “Well I can only lose all my investment.” This is true. Although it may sound silly to say, when you buy long, the most you can lose is 100%. At the same time, your potential profit is unlimited. If you bought shares in Apple decades ago and held on, your profits today would be astronomical.

On the other hand, if you sell short your maximum profit is 100% and your possible loss is astronomical. A short seller profits if the price of the stock declines and the lowest it can go is zero. So your maximum profit is 100%. On the other hand, imagine some poor soul who sold Apple short. But the sky’s the limit on your possible losses on a short sale. This is yet another reason I think short selling is best left to professional risk takers.

Finally, short selling is a margin transaction. The margin protects the brokerage firm from losses they might incur in handling the short selling account. If you take a long position by purchasing a stock, you are required to pay for the purchase. There is no financial risk to the brokerage firm even if the stock goes to zero. The short seller has paid for the stock and owns all the loss.

But on a short sale, none of the potential loss is covered. if the price of the stock goes up even the smallest amount, the short seller has lost money and the brokerage firm is at risk. Rather than calling the client every day to cover his loss, the brokerage firm requires the short selling client to put up money to cover some of the possible loss in advance. This called “margin” and needs to be covered with money or a margin loan. But if the stock goes up in price, it opens the door for the dreaded margin call. This means the stock has gone up enough so that losses eat up the margin so it falls to an insufficient level and the investor has to put in additional capital. If they don’t have sufficient resources to cover the margin call, the brokerage firm is required to buy back the stock which crystallizes the loss for the investor.

Finally, the fees for borrowing the stock to sell short and the cost of the margin, make short sales a generally high cost transaction.

In theory, short selling decreases the volatility of the stock market. As most investors are buying and selling, short sellers are selling and buying. These activities tend to cancel each other out. Also some market contrarians see a high level of shorts as a positive indicator. To them it means many people are negative and that is positive to a contrarian. Other investors reach a practical conclusion. Each share sold short represents a share that has be purchased in the future. So it represents buying potential.

As you might imagine, just prior to the announcement of the Constellation/Canopy Growth transaction, the level of shorting in the Canadian licensed producers was at a relatively high level. Investors argued the stocks were generally overpriced and several stocks had performed exceptionally well. For example, on August 15, 2018, when the deal was disclosed, Aurora Cannabis was on the list of the Toronto Stock Exchange 20 largest short positions.

Also on August 15, 2018, there were 19.3 million Canopy shares that had been sold short. Two weeks later, the short interest on Canopy was 11.2 million. In other words, shorters covered by purchasing 8.1 million shares. But shorting remained strong. Data in an article by Geoff Zochodine in the Vancouver Sun newspaper reports that during the same time period, the short interest in Cronos Group (NASDAQ: CRON) increased from 16.2 million shares to 17.2 million shares. As we reported last week, Cronos was the target of a hatchet job by Citron Research. Shortly after Citron slammed Cronos, the stock dipped under $10 but it recovered and currently it is over $16 a share. This was not a profitable short recommendation in the short term. At the same time the shorts against Tilray, one of the darlings of the NASDAQ since going public, increased from 1.86 million shares to 2.15 million. It is probably hard to put a short together on Tilray because the float is still extremely small so borrowing stock must be difficult.

What’s the message? For most average or inexperienced investors, shorting is not something to engage in. I mentioned there are some option strategies that involve shorting but that is a different issue and still not for the typical person. Just remember, when you short your profit is limited to 100% and losses can be infinite and can reach out to bleed assets over and above what you initially invested. Stick with buying long where all you can lose is what you have invested and your profits are unlimited.

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