Short sellers have big stature on Wall Street.
The “short” part doesn’t have anything to do with their physical height but it has much to do with their psychological and practical approach to the market. While most investors buy stocks to benefit from rising prices, shorts sell stocks to take advantage of falling prices.
It works like this: A trader who thinks a company is going to fall borrows 1,000 shares of it from a broker. He then immediately sells 1,000 shares, for, say, $50 each. He now has $50,000 in cash but is “short” the 1,000 shares.
Important question: The investor now has $50,000. What does he owe his broker?
If you said, $50,000, try again. The investor did not borrow money, be borrowed shares and it is shares he must return.
Now, when and if the share price falls, say for example to $45, the investor buys back the shares for $45,000, returns them to the broker and pockets the $5,000 difference.
This investor still made money the only way it's made in the stock market: He bought low and sold high; he simply did it in reverse order.
The Risk of Short Selling
The risk of short selling is that the stock will rise instead of fall, forcing the investor to buy back what he sold at a higher price, thereby losing money in the process. (Hence the Wall Street adage: "He that sells what isn't his'n / buys it back, or goes to prison.") And keep this in mind: The upside of short selling is limited, as a stock's price can only go to zero. The downside, however, is infinite -- a stock price can theoretically rise forever. And, should good news or peace break out -- heaven forbid -- a rally can turn into a feeding frenzy as shorts desperately try to cover those positions to limit losses. Such a surge in demand can lead to a so-called short-covering rally that can drive prices even higher, further magnifying losses.
Short sales are reported by the New York Stock Exchange and the Nasdaq twice a month. This information can be valuable for investors seeking to handicap stocks. A serious investor always considers the short interest in his or her fundamental research: A large short interest indicates a serious negative sentiment toward the stock, much like a wide point-spread in a Vegas sports book. It’s worthwhile to consider why shorts foresee a drop in the share price. They might well know something you don’t, and it’s crucial to figure out what that is.
Measuring Short Sales
Because the number of shares outstanding swings widely from company to company, Wall Street needed a way to compare short interest. The tool investors devised is called the short-interest ratio. It's calculated by dividing the total short interest by the stock’s average daily volume.
If a company has five million shares short, for example, and daily volume of a million shares, the short interest ratio is five: 5 million / 1 million = 5. The result -- that is, five -- is the number of day’s trading it would take to cover all the shorts. The higher the short-interest ratio, the greater the negative sentiment for the company and, ostensibly, its prospects.
But what if -- now that we understand this perfectly normal and accepted practice of short selling -- we turn an upside-down idea upside-down again? This will straight-up tell you what stocks no one wants to bet against.
To analyze this opportunity, I took the S&P 500 Index and sorted it by short-interest ratio. I used a high-octane stock screener for this, but the information can be found on free financial websites, including Yahoo Finance. (Just enter a ticker and click on "Key Statistics." You'll find short interest under "Share Statistics.")
Insider's tip: The best site for information on shorting, also free, is ShortSqueeze.com.
Here are the top ten companies with the lowest short interest:
|1.||Bank of America (NYSE: BAC)||0.28|
|2.||IMS Health (NYSE: RX)||0.38|
|3.||Genworth Financial (NYSE: GNW)||0.39|
|4.||Citigroup (NYSE: C)||0.46|
|5.||Boston Scientific (NYSE: BSX)||0.46|
|6.||Marshall & Ilsey (NYSE: MI)||0.51|
|7.||Discover Financial (NYSE: DFS)||0.52|
|8.||Apple (Nasdaq: AAPL)||0.55|
|9.||Pall Corp. (NYSE: PLL)||0.56|
|10.||Monsanto (NYSE: MON)||0.58|
What the List Means
As you can see from the list, all these companies could cover their short interest in only a few hours of trading. If you're looking for a common theme among them, you might want to pay attention to the banks and financial-services companies that make up half the list. Banks have had a rough go and are hardly out of the woods: Why wouldn't the shorts be lining up against them?
Answer: Uncle Sam.
It's a sucker's bet to wager against the strength of the federal government. Bank of America, Citigroup, Genworth, Discover and M&I have all taken billions of dollars in taxpayer support -- TARP money -- and used it to beef up their balance sheets. Shorts may be contrarian, but they aren't stupid. The U.S. government is the single most powerful financial force on the planet, and as long as that holds true, it's likely that these protected banks aren't going to see a precipitous drop. Remember, shorts only make money if a stock falls.
even without the weight of the federal government behind them, it's easy to see why investors would be loathe to take positions against a revered company like Apple or a worldwide agricultural giant like Monsanto. Pall Corp., a company many investors might not be familiar with, makes special water filters for large industrial customers, such as utilities and factories. If its business stops, so does industry, and shorts evidently consider that unlikely.
Shorts' Opinion on Health Care
The most interesting company on the list, however, is clearly IMS Health, which provides market intelligence on the health-care field. Its business is so extremely vital to the health-care industry as Congress considers reform that even the most pessimistic contrarian sees no downside to the shares. Just as interesting: United Health (NYSE: UNH) and WellPoint (NYSE: WLP), the nation's two largest public, for-profit insurers, also made the list of top 25 least-shorted companies, as did leading health insurer Aetna. The case can be made that Wall Street is betting against health reform -- or at least is not buying into the notion that it will doom these companies.
The short interest ratio is a great tip sheet for investors looking for guidance in a market whose direction can be difficult to discern. Investors who wish to learn more about short selling should talk to their broker. It's possible to sell short using an online discount broker, but it does require a margin account and a certain cash position.
The most promising opportunities on this list -- and remember we're looking for stocks to buy, not sell -- seem to be perennial tech favorite Apple and agriculture giant Monsanto. Apple for its likelihood to produce the next "must have" device and Monsanto for its long-term potential: Between now and 2050, The Economist magazine recently noted, the demand for agricultural goods will increase +70% as the world's population rises by a third.