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."
#-ad_banner-#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: