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Thursday, March 11, 2010 - 14:25
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Thursday, April 1, 2010 - 04:55
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Thursday, March 11, 2010 - 14:25

Inside the Numbers: Profiting from the 'Short Squeeze'

Thursday, March 11, 2010 - 2:25pm

The short seller is the one trader most investors love to hate. Often misunderstood and maligned, the short seller bets prices will fall rather than rise. This doesn't earn the short seller much popularity with most investors (who usually buy a stock hoping it will rise), but it can be a very profitable strategy.

Here's how it works: A short seller thinks a stock's price will fall, so he borrows shares from a broker. He then immediately sells those shares and gets the cash from the sale. At this point, the trader officially has a "short" position in the stock. If the trader is right and the share price falls, he must decide when to buy back the shares at the lower price and return them to the broker. When he does that, the trader pockets the difference from when he originally sold the shares.

If enough short sellers pile on against a stock that's declining, prices can be significantly pushed downward. On the flip side, if short sellers are wrong and a stock begins to rise, a beautiful thing happens for all the "longs" (investors who buy a stock and expect its price to rise) -- short sellers begin to "cover," or buy back their shares. If the stock stages a significant rally, it can create panic buying by shorts, causing what is known as a "short squeeze."

Profiting from this "short squeeze" is the focus of today's "Inside the Numbers" column.

Before we look for stocks that could benefit from a short squeeze, it's important to understand a key metric -- the short interest ratio. This is found by dividing the total number of shares being shorted by the average daily volume of shares traded.

For example, if a company has two million shares short and an average daily volume of one million shares, then the short interest ratio is two (2 million / 1 million = 2), meaning it would take two average days of trading for all the shorts to cover. Therefore, a stock with a ratio of, say, eight, would mean that it would take six more days for shorts to cover than a stock with a short interest ratio of two. But it also means that if a short squeeze does occur, the rally could be much stronger.

Still with me? Good. Now on to this week's screen…

I recently asked the StreetAuthority research team to look for companies that could experience a short squeeze in the months ahead. In order to qualify as candidates, they must not only have an unusually high short interest ratio, but also be profitable with good long-term growth prospects. Here are the criteria we used:

-- Short interest ratio greater than 7
-- Profitable earnings per share (EPS) on a trailing twelve-month basis
-- Long-term estimated growth of at least +8%
-- Operating margins of at least 15%

Here's what turned up:

Company (Ticker)

Business Short Interest Long Term Growth Est. Op. Margin EPS (T12M)
Waste Management (NYSE: WM) Waste Disposal 14.0 +8.2% 16.4% $2.02
McCormick (NYSE: MKC) Food Distribution 11.8 +9.8% 19.8% $2.29
Iron Mountain (NYSE: IRM) Commercial Services 10.8 +18.0% 18.9% $1.08
Brown-Forman (NYSE: BF-B) Beverages 10.1 +13.0% 32.3% $3.15
Moody's (NYSE: MCO) Commercial Services 8.7 +11.7% 36.6% $1.70
Federated Inv. (NYSE: FII) Investment Management 7.9 +8.4% 32.4% $1.93
First Solar (Nasdaq: FSLR) Alternative Energy 7.6 +24.1% 22.6% $7.67
Paychex (Nasdaq: PAYX) Commercial Services 7.5 +12.1% 38.9% $1.37

A few interesting things to note about our list:

  • Two Buffett holdings, Iron Mountain (NYSE: IRM) and Moody's (NYSE: MCO), make the cut. Clearly, Buffett sees something in Iron Mountain that the shorts don't -- he hasn't made any major moves lately and continues to hold about $180 million worth of the stock. Buffett has been selling Moody's lately, and it seems traders are following his lead.
  • With a short interest ratio of 14, investors might be curious to see Waste Management (NYSE: WM) at the top of the list. Bill Gates is apparently a huge fan of Waste Management (it's the Gates Foundation's second-largest holding) and the trash business in general. So what gives? Turns out, Waste Management is trading just -4% below its 52-week high and its average daily trading volume of fewer than two million shares is relatively low.
  • Paychex (Nasdaq: PAYX) is another intriguing name on the list. The payroll service provider's stock is closely tied to unemployment numbers and interest rates. With unemployment likely to come down gradually in the next couple years and interest rate hikes not a matter of "if" but "when," it looks as if the shorts are playing a risky game with this one. Wise investors should be scooping up shares of this company. (More on Paychex here).
  • It should come as no surprise that First Solar (NYSE: FSLR) is on the list. Shares have been known to be volatile, and the company operates in a high-growth industry. But the shares aren't just volatile -- they change hands like hot potatoes: 2.6 million a day on average. This means all of First Solar's 85 million shares outstanding could theoretically change hands in a little more than a month.

    The shorts have had their way lately: at a price of slightly more than $110 a share, First Solar is trading -85% below its 52-week high. First Solar has been beaten up so much lately, in fact, that it's incredibly cheap. Shares currently change hands for 14.4 times earnings -- you would have had to pay an average multiple of 52 during the past two years. First Solar is expected to grow earnings at a +24% clip in the years ahead, yet investors are only paying 17 times estimated earnings. Without a doubt, First Solar looks to be the best short squeeze candidate of the bunch.

If you'd rather profit from a straight up short, you need to check out this week's issue of Double-Digit Trading. In it, you'll discover a healthcare stock set to plunge that could deliver a quick +15% profit.

Brad Briggs does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.