As I've said before, investors can use fundamental data such as the price-to-earnings (P/E) ratio and cash flow -- as well as technical tools such as the simple moving average and trend lines -- to make an educated investment decision and to identify stocks that are most likely to show growth and profits.
Somewhere in between are the so-called "sentiment indicators." Sentiment indicators purport to measure the overall feeling investors have toward a stock or even a stock market trend. The most popular sentiment indicators are short interest and the short ratio.
And by turning the short interest and short ratio theory into practical and actionable investing ideas, I have discovered a unique situation in the retail niche. More on that later.
First, a little explanation on short interest and short ratio...
Short interest is measured by the number of shares investors have sold short and are not yet covered or repurchased. High short interest represents high negative or bearish sentiment on a particular stock or group of stocks.
It's easy to calculate short interest as a percentage: Simply divide the number of shares short by the number of shares outstanding. For example, if a stock has 100,000 shares outstanding and 10,000 shares sold short, then the stock has 10% short interest (10,000/100,000). Short interest numbers are readily available online. A great place to find accurate short interest data is on Nasdaq's website.
The primary way to evaluate stocks with this data is using the short interest ratio, which is the number of days it will take short sellers to cover (close) their entire positions. The short interest ratio is calculated by dividing short interest by average daily trading volume.
Most stock exchanges track short interest on a monthly basis. By watching whether short interest is increasing in a particular stock, we can notice a change of sentiment. If short interest jumps higher by 20% in a particular stock from month to month, then investors would be wise to dig deeper to discover what is making investors short the stock. Even if they don't find anything particularly negative, they can view the short-interest increase as a signal of something happening behind the curtain.
It's important to note that some investors use the short interest and the short interest ratio in a contrarian way. This means high and increasing short interest could actually be a precursor to a short-squeeze rally. With so many shares short, if any good news starts to lift the stock, then the mad dash of the short sellers to cover (close) their positions will force the stock price sharply higher. Other contrarian investors believe high short interest signals the stock has already bottomed because everyone is selling, and therefore it can only move higher.
This conflicting opinion is why investors shouldn't use short interest and short interest ratio alone to make investment decisions. These metrics are best used when combined with other fundamental and technical data to make clear investment choices.
And this is exactly how I found SUPERVALU (NYSE: SVU).
With 4,400 retail stores throughout the United States, this supermarket owner has been in the business since 1870, operating multiple chains of drugstores and pharmacies.
It represents the classic contrarian view of the short ratio and short interest. Short interest is extremely high at nearly 36%, and the short ratio is more than 11, according to the most recent data from Feb. 15. In defiance of these metrics, shares built a double bottom below $2 between July and October 2012 and then rocketed more than 100% higher to the present price of more than $4 in a classic short-squeeze reaction to internal changes and outside interest.
The company has negative equity and has more than $6 billion in debt. When you add in continuously negative same-store sales for the past five years, declining profits and the already ultra-thin margins of the grocery business, this company is a disaster fundamentally.
However, it's critical to note that SUPERVALU is actively attempting to restructure its debt. It has suspended its dividend in an effort to save cash and is closing underperforming stores to help turn the company around.
The company has made progress as it recently sold off five of its grocery chains for $100 million to private investment firm Cerberus Capital Management, which also assumed more than $3 billion in debt restructuring. The deal is slated to close on March 18. It's possible the company will also continue looking for a complete buyout.
In addition, a new CEO and president recently have taken over the reins. If there are no issues with the deal and the company is successful in its turnaround efforts, shares could continue higher. Remember that just two years ago this stock was trading at $10 a share.
Risks to Consider: There is more than 100% upside potential in this stock. However, the company is in dire straits fundamentally. The Cerberus deal could fall apart, easily plunging shares back to their lows. It is a high-risk investment, suitable only for the most sophisticated investors. Only use money you are prepared to lose in this stock. Furthermore, always use stops and position size properly when investing.
Action to Take --> The contrarian thesis based on the short interest and short interest ratio definitely make SUPERVALU a speculative investment. But I think the Cerberus deal is going to close without a hitch and the company's internal restructuring will be a success. My 18-month target on the shares is $9.