BALTIMORE (Stockpickr) -- It's been a rough year to be a short seller. Since January, the S&P 500 has climbed a whopping 26.4% -- and with the new all-time highs that the big index hit this week, it's not showing any signs of slowing down.
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All the way up, stocks that short sellers thought were too expensive to begin with have gotten more expensive. That doesn't exactly do wonders for your conviction in a trade. As the old saying goes, "I don't mind being wrong -- but I don't want to be wrong for long". So when shorts start to cover their bets, it could fuel a short squeeze in some of Wall Street's most hated names.
Historically, that's not out of the ordinary. In fact, buying the most hated and heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28% each and every year. That's some material outperformance during a decade when decent returns were very hard to come by.
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When I say that investors "hate" a stock, I'm talking about its short interest. A stock with a high level of shorting indicates that there are a lot of people willing to bet on a decline in its share price – and not many willing to buy. Too much hate can spur a short squeeze, a buying frenzy that's triggered by shorts who need to cover their losing bets. And with the rally we've been since last November, you can probably guess that there are lots of losing open short bets.
One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.
It's worth noting, though, that market cap matters a lot. Short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same method was used.
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Today, we'll replicate the most lucrative side of this strategy with a look at five big-name stocks that short sellers are piled into right now. These stocks could be prime candidates for a short squeeze in the months ahead.
Salesforce.com
Enterprise software maker Salesforce.com (CRM) has been a consistent short target this year, egged on by climbing share prices and plenty red ink at the bottom of its income statement. As I write, CRM sports a short interest ratio of 13.16. At that level, it would take almost three weeks of buying pressure for short sellers to cover their bets against Salesforce.
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Salesforce is a must-have application for its 100,000 customers. The firm's Web application lets users run business applications that interact with their customer lists, handling everything from sending newsletters to tracking sales. The Salesforce.com platform has a direct, measurable correlation to sales -- and that mission-critical nature of CRM's offering digs a big economic moat for the firm. The subscription-oriented sales model provides attractive recurring revenues for CRM, and it's kept the firm's top line on a very nice trajectory.
It's the bottom line -- marked in red ink -- that's gotten short sellers so excited. And while it's true that CRM has been investing hard in growth (and that management's long-run profitability guesses are a bit on the high side), the firm has the ability to cut costs relatively quickly without risking revenues. CRM is a prototypical short squeeze play. Earnings in February could be the next big catalyst.
Cerner
In a lot of ways, Cerner (CERN) has a lot in common with Salesforce. Both firms produce high-end, wide-moat enterprise software, and both stocks are hated right now. At last count, Cerner's short interest ratio weighed in at 11.29, indicating more than two full weeks of buying pressure at current volume levels for shorts to get out. With a 50% rally in CERN year-to-date, it's a safe bet that short sellers are starting to feel a bit fatigued.
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Cerner provides health care facilities with the hardware and software to implement electric medial records. Today, almost a third of U.S. hospitals use Cerner's Millennium platform to store everything from patient medical data to financial records. It's not just hospitals either; pharmacies and physician offices are using Cerner's platform to manage their records too. With government rules to implement electronic systems for patient records, going to a firm like Cerner isn't just cost-effective, it's mandated by law.
Getting paid is another big incentive for medical facilities to embrace Cerner's Millennium platform. Cerner's offerings cut down the administrative steps needed to get practices and hospitals payments from either insurance companies or government programs. That helps lessen the blow of a costly medical IT package. While CERN isn't cheap at its current valuation, momentum is clearly in favor of shares right now -- and a short squeeze could help push this stock even further.
M&T Bank
There's no two ways about it: Investors hate M&T Bank (MTB) right now. With a short ratio of 10.06, M&T is the most heavily shorted big banking name out there, in fact. But that hate is misplaced.
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M&T is a $15 billion regional bank with a big presence in the mid-Atlantic and parts of the Northeast. Don't let the "regional" moniker fool you -- M&T ranks as one of the 20 biggest banks in the country, with more than $83 billion in assets under its belt. But being a regional bank has historically meant that M&T kept up stricter underwriting rules for its loan book than its bigger peers, and as a result, M&T was charging off less than a quarter of what big banks were still determining to be worthless as recently as last year.
M&T currently sports a 2.4% dividend yield, a payout that puts it on the high end of publicly traded banking stocks. That's also a testament to regulators' opinion of MTB's financial wherewithal. Since dividends need to get approved by the Feds, the bank's payout has gone through some scrutiny. With a rise in interest rates all but inevitable eventually, the spread that M&T is able to earn should continue to widen in the years ahead. That increased earnings power looks discounted right now, in spite of short sellers' presence in this stock.
Fastenal
The nation's warming economic engine is providing some big growth prospects for industrial supply company Fastenal (FAST). Yes, you could certainly argue that Fastenal's business isn't particularly exciting -- it's not. But this stock's growth rates are exciting, with sales and profits expanding in each of the last four straight years.
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Fastenal's business is built on providing must-have supplies to other businesses. One of Fastenal's biggest benefits is its huge product catalog. The firm carries more than 410,000 types of fasteners and more than 585,000 maintenance and repair products, an inventory that makes each of Fastenal's 2,700 brick-and-mortar locations a one-stop shop for its customers. A high concentration of consumables provides recurring revenues for Fastenal -- customers go through products like air filters, paper towels and packaging products on an ongoing basis. Even if margins on those staple offerings are lower, they help attract bigger-dollar sales of power tools and furniture.
It's hard to argue with Fastenal's financials. The firm has been a shining example of internal growth, eschewing debt in favor of using cash flows to finance new store locations and inventories. Still short sellers hate this stock -- and that's propelled shares' to a short interest ratio of 14.88. With three weeks of buying just to cover sellers' bets, FAST is a prime short squeeze candidate.
Staples
With shoppers eyeing big Black Friday sales this week, it'd be a mistake to ignore what's going on at Staples (SPLS). While the office supply superstore is probably best known for supplying offices around the world, the firm is also a huge seller of consumer products -- and it's the second-largest online retailer in the world. Right now, SPLS sports a short interest ratio of 10.37.
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Almost half of Staples' business comes from its corporate delivery business -- the firm's acquisition of Corporate Express in 2008 gave Staples a foothold in the niche, replete with high switching costs and a hard-to-replicate delivery network. On the retail side, Staples' more than 2,000 stores worldwide give it a hard-to-match presence on the ground. A big factor in SPLS' segment-beating margins has been an abundance of private label offerings, from sticky notes to pens. With economies of scale that smaller rivals can't match, Staples can move more SKUs more cheaply than ever before.
The missteps of the other big office supply chains have demonstrated that Staples' business is a tough one to remain competitive in. But the firm's attractive mix of corporate, online, and retail sales combined with deeper margins mean that SPLS currently has a margin of safety that its rivals don't have. With shares outperforming the S&P 500 by around 10% year-to-date, short sellers are a whole lot more sensitive to upside at this point – watch for the next catalyst.
To see these short squeezes in action, check out this week's Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.
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At the time of publication, author had no positions in stocks mentioned.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to
TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.Follow Jonas on Twitter @JonasElmerraji
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