In recent weeks, the only investors to rack up profits have been the short-sellers, who have been riding the downward market to ai their bets on falling stocks. But as stock prices appear to have stabilized (at least for now), should these short-sellers start to think about covering their positions? If they do, then they could add buying pressure (since they buy back borrowed shares to cover their positions), creating an unexpected rally in some of the most heavily-shorted names.
In recent weeks, I've discussed the high short positions in GE (NYSE: GE) [Read "This Well-Known Stock Could be in Trouble" here.], Ford (NYSE: F), EMC (NYSE: EMC) and AMD (NYSE: AMD) [Read "4 Stocks that Could Profit from a " here] .
1. Charles Schwab Corp. (NYSE: SCHW)
Gain since Aug. 15: 0.5%
Fall from : 36%
It's very curious that short sellers hold more than 41 million shares of this financial services stock (which is up 25% from the prior two weeks). There's no reason to confuse Schwab with the big banks that may be hard-pressed to deal with the ongoing crisis in housing or the broader. The real knock against Schwab is its presently weak profits. This is because the firm has always made a decent return in its money-markets funds. But with the Federal Reserve's rates at rock-bottom levels right now, Schwab simply has no way to get any real spreads in the business.
Simply put, it's unclear which catalysts short sellers may be identifying for a further downward move for Schwab -- shares already sit near a six-year low, and currently trade at about $12. But if short sellers seem unlikely to make money on the downside, then what kind of upside might there be? Plenty -- if you've got a one to two-year time horizon. It's all a matter of when interest rates begin to rise: "We think rising interest rates are a near certainty over a longer time frame, with calculable effects on Charles Schwab's earnings. The stock is currently trading at around 60% of our discounted cash flow model fair value estimate of $22 per share," note the analysts at Morningstar.
Nearer-term catalysts also exist. For example, the recent market volatility has brought heightened trading volume, helping Schwab to boost trading commission revenue. We'll have to wait until the current quarter's results are released in late October, but this summer is shaping up to post a solid rebound in market volume. Trading activity rose 11% sequentially in July and a similar gain looks to be in the cards for August as well.
As another catalyst, Schwab is suing major U.S. banks, accusing them of having manipulated interest rates starting in 2007. Schwab says this has "robbed" the company of hundreds of millions of dollars in foresworn fees it could have generated. This lawsuit could either take time to play out, or could move quickly if the banks seek to clear this and all other litigation from their decks.
Of course, the best catalyst of all is rising interest in the stock market. Individual investors have been shunning stocks for much of the past few years and pulled even more money out in the month ended Aug. 10, according to the Investment Company Institute (ICI). A week later, on Aug. 17, the institute announced an unexpected reversal: individuals actually poured $1.5 billion into domestic stock funds that week. If investors feel emboldened to take advantage of the sharp recent sell-off in the market, then a new trend may be getting underway. Schwab, which has been collecting thousands of new clients during the past few years, would surely benefit.
One of the key themes of 2011 has been the robust export performance of mid-sized U.S. manufacturers. Sales into Brazil, China and elsewhere have enabled many companies offset the continued weakness here in the United States and Europe. You can certainly see this bullish trend underway at Timken, one of the world's leading suppliers of ball bearings, where sales are expected to rise 25% this year. The company also makes a range of specialty steels and products for the power-transmission industry.
Timken has topped quarterly estimates four times in a row, leading analysts to boost their profit outlook. After this year's slump, shares trade for less than eight times projected 2012 profits. Despite the solid momentum and cheap valuation, shorts nearly doubled their position in just two weeks to 1.1 million shares. They likely remember Timken saw sales slump badly in 2009 and anticipate another global downdraft to come. But Timken's solid quarterly results give no credence to this view. Another strong quarter and shorts may need to run for cover, creating a nice short squeeze.
3. Sealy (NYSE: ZZ)
Gain since 8/15: 13%
Fall from 52-week high : 34%
Mattress maker Sealy briefly saw its shares dip below $2 before a recent rebound. Short sellers are targeting the company as it keeps losing market share to fast-growing Tempur-Pedic (NYSE: TPX). The market-share loss could be tolerated if so many potential customers weren't holding off buying new mattresses right now.
Against all this bleak news, Sealy appears to be reversing recent negative sales trends, boosting sales in the United States and Europe at a 10% clip in the second quarter. This is the payoff from an upgraded line of "Posture-pedic" mattresses that are squarely aimed at Tempur Pedic's customers.
Short-sellers also notice the too-high levels of debt, which stands at nearly $800 million. Only $2 million of this debt comes due in the next 12 months, however. Meanwhile, earnings before interest, taxes, depreciation and amortization (EBITDA) exceeds interest expense by about 50% (or $10 million) a quarter. Obviously, a slip into recession would pressure shares further as interest coverage wanes. But the recent sales gains, along with a long-awaited replacement cycle for increasingly lumpy mattresses, could help boost EBITDA, giving the stock an "option-like" upside.
Risks to Consider: These stocks will only benefit from any short-squeeze in a flat or rising market. Any further market weakness would give even more breathing room to short sellers.
Action to Take --> The market has indeed looked a little healthier in recent sessions. Any time you see a rally after a major pullback, you should give a close look at the heavily-shorted names, because they can post explosive near-term upside as shorts run for cover. In particular, keep an eye on the three names I mentioned in this article, because their upside potential goes beyond the short term.