Here’s Where Short Sellers Can Make Huge Profits!

With higher interest rates potentially right around the corner (again), Canadian investors may want to begin thinking about the investing process very differently. As consumers and companies have gotten used to lower interest rates, the idea of pondering a major purchase or undertaking a major capital project has become almost routine. With such low rates of interest, financing these activities has become much too easy, which has led to a lot of spending and substantially higher corporate profits on a temporary basis.

Since interest rates have started to increase (and are expected to increase further), there are a number of stocks that have declined in value by substantial amounts. These are the value investments preferred by retired investors seeking income. The explanation is very simple: as the risk-free rate of return has increased, companies paying the highest dividends are less attractive, as the spread between the yield and risk-free rate of return has declined. In order to increase the yield, the price has to decline in value.

Many other securities that are somewhere between the value and growth categories have not experienced the same fate. In many cases, these are companies that are reaching a mature status and are only starting to require capital expenditures for maintenance purposes instead of for expansion. Although the dividend may be nice to receive, it is not the reason that investors seek out these names.

An excellent example of this is none other than Toromont Industries Ltd. (TSX:TIH). At a price of $58, Toromont may be a prime candidate for short sellers. The company is in the business of selling heavy machinery (capital equipment). Unfortunately, it’s in a cyclical business that tends to outperform the market during good times and underperform the market during difficult times. As Canada has experienced an unprecedented decade-long bull market, it may make a lot of sense for investors to ask this question: How much more capital equipment can be bought if interest rates continue to rise?

The reality is that business for this company (a high-quality company by all accounts) may have nowhere to go but down.

For those seeking confirmation of this, the proof may just be in Canada’s airline industry and in the alternative lending industry. In both cases, there are a number of companies making substantial corporate profits, yet stock prices continue to trade at lower multiples, as the market seems to be pricing in a major decline in earnings (and potentially a recession). Many who are old enough will remember the “good old days” prior to 2008, when stock prices reached their highs in 2007 — the year before the Great Recession. Why would this market cycle be any different?

Although short selling may be risky for some, the reality is that there are many securities that are substantially better priced for those seeking dividends and capital gains.

Happy investing!

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Fool contributor Ryan Goldsman has no position in any of the stocks mentioned.

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