The big (shrinking) short list

What are we looking for?: Canadian companies with a reduction in short interest

The screen

Short-selling, or “shorting”, refers to the investment practice of borrowing shares and subsequently selling them in the hope that the shares will eventually decline, so that the borrower can buy the shares back at a cheaper price to return to the lender, thereby pocketing a profit.

While seemingly simple, this investment strategy is not for the amateur investor and poses a significant amount of downside risk. When considered as part of the investment research process, it does, however, give a good indication of the general sentiment surrounding a stock.

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For example, if an increasing number of investors are choosing to short a particular company, it’s fair to say that this group believes the stock is going to drop in value. For the average investor, this could be considered a poor indicator for the company’s success.

Today we follow a strategy looks for Canadian companies which have experienced a reduction in the amount of their stock that is shorted across the past year. This strategy ranks stocks based on:

• One-year percentage change in short interest – as defined above; low values preferred
• Five-year beta relative to the S&P/TSX index (measure of a company’s sensitivity relative to changes in the benchmark – a value less than 1 would indicate the stock is less volatile than the market; low values best)

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In order to qualify, stocks must have their one-year per-cent change in short interest less than or equal to negative 5%, meaning that at least 5% of the outstanding short position has been covered (or closed out) in the past year. Stocks must also have their five-year beta relative to the S&P/TSX less than or equal to one to reduce sensitivity to changes in the market. Lastly, stocks market capitalization must be greater than or equal to $250 million to avoid micro caps.

What we found

I used Morningstar’s CPMS data tool to back test this strategy from March 2004 to April 2018. During this process, a maximum of 15 stocks were purchased. Stocks were sold if their ranking fell below the top 50 per cent of the Canadian universe or if the company’s five-year beta rose above 1.

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When sold, the positions were replaced with the highest-ranked stock not already owned in the portfolio. Over this period, the strategy produced an annualized total return of 14.6% while the S&P/TSX Total Return Index returned 7.2% across the same period.

The strategy performed very strongly over the back-test time period, beating the benchmark by a net increase of 6.7%, 12.2%, 10.2%, and 10.5% over the 1, 3, 5, and 10-year time periods respectively. Another point worth noting is that the strategy outperformed its benchmark in down markets (measured as quarters in which the benchmarked had negative returns) 95% of the time, indicating extremely strong downside protection.

This is echoed in the strategy’s standard deviation (variability of total returns) of 9.7% vs the S&P/TSX index standard deviation of 12.4%, as well as a downside deviation (variability of negative returns) of 5.5% relative to the benchmarks 8.7%.

Stocks that qualify for purchase into the strategy today are listed in the accompanying table. As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed below.

Emily Halverson-Duncan, CFA< is a Director, CPMS Sales at Morningstar Research Inc. Morningstar provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, covers more than 95 per cent of the investable North American stock market.

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