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That’s not just my opinion; the data bears it out as well. Going back over the last decade, buying 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.
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 strategy is used.
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 final push of 2012.
In case you're not familiar with the term, a "short squeeze" is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors, causing share price to skyrocket. 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.
Naturally these plays aren't without their blemishes. There's a reason (economic or otherwise) that these stocks are being heavily shorted. But for investors looking for exposure to a speculative play with a beefier risk/reward tradeoff, these could be powerful upside plays for the coming year.
Here's a look at our list of large-cap short squeeze opportunities.
First up is GPS giant Garmin GRMN. Garmin is on short sellers’ perennial hate list, with a short interest ratio of 18.45 -- that number indicates that it would take short sellers close to a month to cover their short positions in this stock. Much of that animosity comes from Garmin’s bread and butter: Personal GPS devices for in-car navigation. While these units fuelled Garmin’s growth in years past, they’ve become increasingly commoditized more recently, with margins shrinking as competitors take extremely similar products to market.
But short sellers have been wrong about Garmin’s shrinking business to date -- and in fact, the personal GPS market actually grew quickly in the last quarter, much to the chagrin of shorts. At the end of the day, Garmin’s big advantage in the personal GPS market is its presence in other niche markets for navigation equipment: Aviation, marine, and outdoors. Because Garmin is the league leader in aviation (where its $30,000-plus G1000 glass cockpit system is standard equipment on most small planes today), the firm is able to fuel R&D spending that trickles down to the simple devices that it sells to consumers.
Garmin has been working on a similar big-screen concept for cars, which would follow the same model as the G1000 -- Garmin makes the system, and manufacturers simply integrate it into their vehicles. That opens the doors to considerable growth opportunities for Garmin that its rivals just don’t have. Most rivals also don’t have Garmin’s combination of a debt-free balance sheet, huge margins and $2.7 billion in cold hard cash. Longer term, this stock looks primed for a short squeeze.
Alliance Data Systems
Companies want to know what you do -- tracking consumers’ preferences has become big business for marketers in the last decade. That’s helped to fuel a nearly 40% rally this year in Alliance Data Systems ADS. ADS provides marketing and loyalty services for other companies, handling more than 120 million customer relationships with a specific focus on Canada, where its Air Miles subsidiary operates. From gas stations to airlines to banks, Alliance Data is all about outsourced customer relationships.
But short sellers aren’t buying the rally. ADS currently sports a short interest ratio of 14.6, which means that it would take close to three weeks of buying for shorts to get out of this stock at current volume levels. That makes ADS a solid short squeeze candidate right now.
Alliance generates double-digit net margins for its trouble, while at the same time building itself an attractive moat. With clients’ customer lists and very long-term contracts as standard, revenues are stickier than they would be if ADS didn’t own many of the networks that it administers for firms. The same is true of the firm’s private-label credit card business. By using the same network that manages loyalty programs, ADS has been able to enter a lucrative market with extremely high barriers to entry. Earnings on January 28 could be a big short-squeeze catalyst for this stock.
South Carolina-based electric and gas utility, SCANA Corporation SCG, serves power and natural gas to around 1.5 million customers spread across three Southern states. Typically, regulated utilities are beloved by the most risk-averse investors, but not SCANA; the $6.1 billion firm currently has a short interest ratio of 13.27.
SCANA isn’t just involved in distribution -- it’s a major non-regulated infrastructure owner, with a big power generation arm, transmission assets and a fiber optic communication network. Vertical integration gives the firm net margins that weigh in the double digits; a healthy balance sheet gives SCG access to enough dry powder that it can handle a few economic potholes in the next couple of years. Exposure to high-margin nuclear energy gives SCG some big profitability advantages, especially as the firm works on building new nuclear plants in South Carolina.
For a utility stock, the dividend is everything -- and for shorts, the most common downside scenario comes from the possibility of a dividend cut. While SCANA’s payout is hefty at 4.3%, the firm generates enough cash to cover its obligations for the foreseeable future.
Dick’s Sporting Goods
Sporting goods retailer Dick’s Sporting Goods DKS has managed a slam-dunk this year -- shares of the $6.2 billion firm have rallied 38% since January. But anxious investors have been taking the other side of the DKS trade all along the way -- the firm’s short-interest ratio currently stands at 10.14.
Dick’s is the league leader in the sporting goods business, with around 500 big box stores spread throughout the U.S. and another 81 Golf Galaxy locations under its belt. Because of its size, DKS can negotiate favorable contracts with suppliers that typically have the pricing power in the relationship. It also means that the firm can reap major supply-chain benefits and absorb costs across its entire store network, making merchandising improvements that much more attractive. Even though Dick’s is the biggest game in town, however, there’s still enough room for this chain to expand at this point.
With a product mix that leans on the higher-end, Dick’s has built in enough big-margin offerings to generate margins that other retailers can’t easily pull off. As the firm increases its private label offerings in its stores, those margins should keep growing.
Realty Income Trust
Last up is REIT giant Realty Income Trust O, the commercial landlord that’s known to income investors as “The Monthly Dividend Company”. The firm’s strategy is built around investing in neighborhood shopping centers anchored by supermarkets, with 50 million square feet of leasable space in its portfolio.
Even though the real estate crash shoved Realty Income lower when the recession hit, conservative business practices -- such as buying existing properties with proven performance, and mitigating the risks of leasing to retailers with limited financial wherewithal -- have helped the firm thrive post-recession.
As with utilities, the threat of a dividend drop is the big short catalyst for income-centric investments like REITs. Because REITs like O are legally obligated to pay out the vast majority of their income directly to investors in the form of dividends, they can get forced to cut payouts more quickly than firms with lower payout ratios. That said, while Realty Income doesn’t carry mountains of cash on its balance sheet, it does generate enough consistently to easily support its payout going forward.
The firm’s 4.82% dividend yield doesn’t look in peril right now.
That could come as a nasty surprise for shorts as carrying costs eat away at their possible returns. Currently, Realty Income has a short interest ratio of 12.22.
To see this week’s short squeezes in action, check out the Large-Cap Short-Squeezes portfolio on Stockpickr.
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.