It’s widely believed that Wall Street takes advantage of Main Street.
Wouldn’t it be nice to take a little piece out of hedge fund returns?
The market has been on a ballistic run since the beginning of the year with “long only” funds dramatically outperforming hedge funds. Money flowing into the winners has driven the market to new highs, but it’s difficult to jump in and buy names such as Google (Nasdaq: GOOG) at all-time highs after it missed the last two quarters’ revenue expectations.
Safer names can offer a decent yield at a lower beta. Johnson & Johnson (NYSE: JNJ), for instance, has a yield of 3.1%, which compares favorably with the 10-year Treasury at 1.7%. The downside is that the stock is up 20% so far this year. Moves like this are dramatic but not unprecedented. In 2004, the share price rose 23% and in 1998 it rose 27%, not including the returns from dividends.
But there are stocks that could grow dramatically in the coming months as hedge funds are forced to cut their short positions in a thin market, causing short squeezes. A short squeeze is like trying to grab an ice cube. Just like grabbing a wet ice cube from a cooler, you need just two things to get this mini explosion: pressure and a sudden lack of friction.
A Quick Refresher on Short Squeezes
In investing, short interest is what causes the pressure. Investors have sold stock that they borrowed, expecting the price to drop. However, if the price of the stock starts to rise, these funds are forced to buy back the shares they borrowed, which drives the price even higher.
Let’s take a look at two real-world examples: Apple (Nasdaq: AAPL) and Tesla (Nasdaq: TSLA).
At the end of March, Tesla announced that it would be reporting profit earlier than expected. Unfortunately, rather than covering, shorts added to their positions, driving the stock down 15% from $46 to $40. The pressure was short-lived as more positive news emerged, leading the stock to double.
Unlike Tesla, Apple isn’t even seeing its fortunes improve yet, but they are less bad than what people expected.
AAPL announced weak first quarter growth in mid-April, but margins didn’t fall as much as investors expected, offering the hope for improved future profitability.
AAPL didn’t wait for investors to step in; it announced a debt offering that would fund a massive share buyback. This time the shorts didn’t wait… they drove the stock up $70 points or 18%. This is a dramatic move for a company that is seeing increased competition.
Moves like these were the warning shots to short sellers and there are likely more to come. Whether the economy improves or not, whether the unemployment rate is real or not, if the price of a stock is going up, it is costing short sellers money each and every day.
Three Stocks With Short Squeeze Potential
We screened the entire universe of technology companies to find three that are growing, likely to benefit from an improving economy and have high short interest.
First, Vistaprint (Nasdaq: VPRT) provides printing services to small businesses and households. The company is profitable and has nearly half of its shares that are available for trading held short! The stock has been appreciating but is still only trading at a P/E of 18. A sustained improvement in small business spending on advertising and promotional gifts would increase earnings growth and cause shorts to run for cover.
Next, BlackBerry (Nasdaq: BBRY) is considered by many to be the next Palm or Nokia. However, a wide international distribution network and niche fan base in corporate computing environments that like and want keyboards on their smartphones represent a high margin opportunity for the company.
Finally, OpenTable (Nasdaq: OPEN) is an online restaurant reservation system that benefits from an increase in discretionary income. Since the stock market is breaking all-time highs at a seasonally strong period, an increase in consumer spending could have a dramatic impact on valuation of this internet business.
It may seem counterintuitive, but the key thing to think about when watching short squeezes is that it doesn’t matter why the stock is going up – it matters that it is going up. The momentum of a stock move forces unhappy hedge fund managers to admit defeat and close their positions at a loss… potentially causing a big gain for you.
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