July 2017 – An Editorial on the Dynamics of Short Trading in the Canadian Markets
It was April 27th, 2017 and we woke up to a press release stating that the Canadian alternative lender, Home Capital Group Inc. (HCG – TSX), was in talks to secure a lifeline of $2 Billion! A lifeline? How can this be? Only a few weeks prior, analysts were calling Home Capital unduly cheap, and in the worst case, a stock with a “market perform rating”. Well, after having suffered the effects of negative allegations by the Ontario Securities Commission, the stock dropped precipitously to the $6 dollar level. This market action came as a shock to many and was a serious fall from grace from the 52 week high of over $32 dollars.
HCG 1 Year Performance (Source: StockWatch)
As the chips slowly start to fall, and cases such as the Home Capital debacle come to light, it is becoming more and more evident that Canada’s real estate market could be teetering precariously on the edge. Money was flowing like water as real estate speculators, especially those in Vancouver and Toronto, were trading houses and condos like stocks and reaping huge levered returns.
For Home Capital, problems arose when it was discovered that some numbers may have been “fudged” in order to get mortgage applications pushed through the “B-Lender” system. Home Capital is known as a B-Lender, which means that they primarily offer uninsured mortgages to clients who are turned away from banks for whatever reason. The “A-Lenders” of the world, the big banks such as TD, RBC, Scotia, etc. generally offer more vanilla mortgages at cheaper rates to the highest credit quality clients. B-Lenders, on the other hand, generally take on more risk but also charge higher rates.
The problem as of late is that it is getting more and more difficult to secure money from A-Lenders for a larger portion of the population. Sure, if you are a doctor, lawyer, dentist or school teacher, just come on in to your local bank branch with two years of NOA’s and you are generally pre-approved by the computer. On the other hand, if you are self-employed and paid yourself $20k last year and kept most of the money in your business, good luck. You’re screwed! Well, maybe not so fast! Find a private mortgage broker and with an “in” through Home Capital, or another such B-Lender, and you might be okay after all!
Home Capital saw this opportunity long ago and capitalized on it. Similarly, investors and speculators alike saw an opportunity to get onboard and ride the wave in the surging market, where negative cash flowing properties were still a “BUY” as investors were in it for property appreciation and not the monthly residual. Soon enough, after a few years straight of double digit housing price increases, the government started to realize that we might have a problem on our hands. Government intervention in free markets is rarely ever a good thing, but they intervened regardless and the first step was the stress test. Essentially, the government put a new rule in place whereby if you are getting a mortgage you need to qualify using 4.64% as your interest rate. You could still get your 2.59% variable rate at Scotia, but just in case they wanted to ensure that if things got crazy, such as an interest rate spike (like what happened in the 80’s), for a while at least, mortgage payments would still be met. This makes sense for the perfect 9-5 couple with two clean NOA’s looking to buy their overpriced $1.5M home in Bloor West Village, but for the self-employed speculators, it made no difference. They were paying 4.99% now! If you wanted to get into the market now, you had to pay. Money isn’t free. But if you can use someone else’s money at 4.99% and flip a property in 3 months for an easy $100,000 why wouldn’t you? The government realized this and continued their push to slow-down the market in Ontario by copying BC’s foreign investor tax, regulating AIRBNB and announcing a stop to condo assignments (when you buy a pre-construction condo because you waited in line for 4 hours only to sell the right to buy that condo for a handsome profit a month later before a crane ever even lands on the site). So, what did this mean for Home Capital and specifically its publicly traded stock? All of these negative factors allowed for some very clever people to create a HUGE SHORT POSITION in Home Capital’s stock. Our partner website, ShortData.CA, had been tracking Canada’s most shorted stocks, and noticed Home Capital among others in their sector getting crushed:
Between April & May over $459 Million dollars (almost half a Billion) was shorted on HomeCapital!!
The fact of the matter is, the market isn’t perfect. However, Home Capital was likely never quite as bad as it was made out to be. Markets tend to overact on both sides of the equation – to the upside and also to the downside. It just so happened that Home Capital was cleverly “attacked” by various media pundits and observers in such a way that it allowed some VERY shrewd investors, “THE SMART MONEY”, to capitalize on the situation by using their deep pockets and expertise to PROFIT HANDSOMELY on the SHORT SIDE of this trade. Sadly, Home Capital, a company that provides a seemingly important service to a niche market in the Canadian lending landscape almost fell to the matt for a 10-count and didn’t get up.
Interestingly, almost as quickly as Home Capital fell, the wild roller-coaster ride turned in the other direction when it was announced that none other than the legendary ‘Oracle of Omaha’, Warren Buffett, came into the picture and decided to invest in the company. What better test of confidence for a teetering enterprise can you possibly get than for a guy like Buffett to write a cheque. He rarely steps outside of the USA, and the fact that he came into Home Capital shows how things can quickly change in these volatile markets, especially when you get the algo’s trading upwards, instead of their usual downticks and arbitrage tactics.
The problem is that Home Capital is not the only example of a Canadian company getting “killed” in the market by aggressive short selling strategies. There are countless companies, both in and out of the small cap arena, that are facing this problem. Of course, the issue is only exacerbated when the companies are small/micro cap issuers who are start-up in nature, generally undercapitalized, and never have the ability to properly execute on their business plans as machine trading and deep pocketed sharks are right on their doorsteps hitting every bid that appears. These sharks know that in the end they will win as, eventually in today’s market, retail investors/traders get bored/scared rather easily and will jump ship from a deal in a split second if they think they are missing out on a new hot promotion that hit the street and will forget about that smallcap that was just trying to build their business only to find themselves dead in the water as their structure has been blown up. What happens when a company has to raise funds at artificially low prices? Dilution. What happens when short sellers realize private placement paper is coming off restriction, or the company needs to raise more money? They SHORT it more!
This investment paradigm is a reality of the markets we are in. Don’t stand by and suffer. Arm yourself with all of the information and tools that you need to succeed in these every changing and treacherous environments. One such tool to consider in your repertoire is our new newsletter: “SHORTDATA.CA SQUEEZE ALERT”. We welcome you to join this free publication to track future short-squeeze opportunities, such as Home Capital, and take back your markets from the algorithmic traders and sharks on the other side of the equation. So, arm yourself! Fight fire with fire and PROSPER!
Disclosure: We do not hold an equity position in HCG