Cannabis companies in both Canada and the U.S. have endured a brutal slide in valuations over the past 6 months. A major contributor to this downturn has been the very aggressive shorting of marijuana stocks.
Obviously, traders shorting cannabis companies over this period have done very well. A recent Seed Investor article noted that the Canadian Marijuana Index has fallen by roughly half over that time.
However, the party (for short sellers) appears to be over. Valuations for Canadian cannabis stocks are now at nearly a 2-year low. But cannabis retail sales in Canada have ignited.
As Canada’s provinces have finally began to license a sufficient number of retail storefronts, cannabis sales have been rising at a double-digit pace. Backward-looking quarterly earnings for Canadian companies are just beginning to reflect this more robust level of sales.
Some of Canada’s largest cannabis markets (notably Ontario and British Columbia) are still laggards in opening new cannabis stores. This means that this growth in retail sales is just beginning.
Meanwhile, Phase 2 of cannabis legalization in Canada will not only introduce a vast array of new, higher-margin cannabis products. It is also expected to generate roughly 3 million new consumers (for the legal market), increasing the overall consumer base by more than 50%.
But the large short overhang in the cannabis sector remains. The top 20 most-shorted cannabis stocks have an average short position of float of 15.8%. Over US$5 billion in short selling is currently spread among 150 cannabis stocks.
A September 11, 2019 article from Benzinga identifies the 14 largest short positions in the cannabis sector, by dollar amount. Not surprisingly, Canopy Growth (US:CGC / CAN:WEED) leads the way.
As the industry leader by market cap, Canopy Growth has a total short position of US$1.27 billion. This is more than 4 times as large as the current short position on Apple (US:AAPL) by trading volume. The short position for NASDAQ-listed Cronos Group (US:CRON / CAN:CRON) is over 5 times as large.
Other Canadian-based companies with extremely large short positions include Aurora Cannabis (US:ACB / CAN:ACB) US$922 million, Tilray (US:TLRY) US$213.9 million, Aphria (US:APHA / CAN:APHA) US$210.3 million, HEXO Corp (US:HEXO / CAN:HEXO) US$182.2 million, and Green Organic Dutchman (CAN:TGOD / US:TGODF) US$41 million.
In short (no pun intended), cannabis short-sellers are currently positioned for a bloodbath – their own. And that means the potential for an enormous short squeeze.
At least one financial institution is already anticipating this. Bank of Montreal is no longer allowing shorting of cannabis stocks, meaning it has ceased to lend out cannabis shares for shorting.
The reason cited by the Bank for this move is “high volatility”.
In the realm of short selling, high volatility can indicate one of two things, it can indicate traders making lots of money (as did happen over the past 6 months), or, it can mean pigs getting slaughtered.
Banks love to make money. If BMO saw cannabis shorting as a profitable trade going forward, they would continue to backstop it. Obviously, BMO is internally forecasting that short-sellers are going to be absorbing substantial pain – and it’s looking to cut its own losses.
This comes in the context of high borrowing costs for short sellers, further under-cutting margins. As an example, a September 2018 article observed at the time that it was 200 times more expensive to short Aurora Cannabis than “a basket” of major U.S. companies, like Apple, Amazon (US:AMZN), and Goldman Sachs (US:GS).
The market situation in the U.S. cannabis industry is murkier at present, since it is so dependent on continued progress on the regulatory front. And U.S. politicians are notoriously capricious when it comes to cannabis.
However, any strong rally in Canadian cannabis stocks would also be the catalyst for a U.S. rally. U.S. marijuana stocks are already discounted relative to their Canadian peers due to this regulatory uncertainty.
Naturally, U.S.-based companies are also heavily shorted. This includes industry leaders like GW Pharmaceuticals (US:GWPH) US$562 million, Charlotte’s Web (CAN:CWEB / US:CWBHF) US$55 million, and Medmen Enterprises (CAN:MMEN / US:MMNFF) US$19.8 million.
This would not be the first time that the (short) pigs have gotten slaughtered in cannabis. A February 27, 2019 article noted that cannabis short sellers lost over $200 million in that month alone. Ouch.
The cannabis shorts have set themselves up for an epic short squeeze. It’s one more reason why cannabis longs should be expecting a strong rally in cannabis stocks, starting in Canada, and sooner rather than later.