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Trade 5 Hated Names to Beat the Market - views
BALTIMORE (Stockpickr) -- If you want to beat the market consistently, you've got to be willing to look at the names everyone else hates. That's not just an opinion -- the research bears it out too.
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 was 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 last quarter 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.
Without further ado, here's a look at our list of large-cap short squeeze opportunities.
Johnson & Johnson
First up is $195 billion healthcare firm Johnson & Johnson (JNJ), a name that most investors wouldn't expect to see in short sellers' crosshairs. JNJ is the prototypical blue chip stock -- not only does this $180 billion healthcare firm boast a diversified business and enormous scale, it also enjoys a huge $17 billion cash position. Still, shorts have been betting against this firm for a while now. At last count, JNJ's short interest ratio weighed in at 13.9, indicating that it would take nearly three weeks of buying pressure at current volume levels for short sellers to close their bets.
Johnson & Johnson is about as diversified as a healthcare firm can be. The firm's business includes everything from consumer products like Band-Aid brand bandages to pharmaceuticals and medical devices. While drugs makes up a large chunk of the firm's profits, the consumer and medical device segments offer investors diversification that few big pharma names can match -- especially as patent drop-offs plague valuations in the industry. JNJ has been pouring money into medical devices of late, most recently with the $19.7 billion Synthes acquisition that was completed this summer.
JNJ's combination of exposure to a growing industry (healthcare demographics in the U.S. lean in the firm's favor over the next few years), plenty of liquidity on its balance sheet, and recession resistant revenue sources makes this firm an attractive core holding for most investors. The 3.4% dividend yield that JNJ pays out doesn't hurt either. As short sellers get shaken out, this stock could see a pop in share price.
H.J. Heinz Company
Chances are you're familiar with H.J. Heinz Company (HNZ) -- the $18.6 billion food firm boasts brands that are nearly ubiquitous in Americans' pantries, most notably its namesake ketchup. Today, though, Heinz's product portfolio goes way beyond everyone's favorite condiment -- Heinz manufactures everything from soup and baby food to Ore-Ida frozen French fries.
Heinz has long had significant international exposure, but more lately the firm has been focusing its overseas sales in emerging market countries, which have ballooned in scale to make up around a quarter of total revenues. That's impressive exposure, particularly as burgeoning middle class diners spend more on prepared foods. Heinz is no slouch here at home, though. The firm has a massive foothold in the restaurant business, with those little ketchup packets at McDonald's (MCD) and the bottles on the table at Red Robin (RRBG) contributing 15% of sales.
More normal financial markets bode well for Heinz, especially if it means that the dollar cracks its multi-year rally -- since HNZ generates around 66 cents overseas from every dollar it earns, a weak dollar is a boon to earnings. Meanwhile, short sellers have been making concerted bets against this stock; with a short ratio of 10.5, it would take more than two weeks for shorts to cover their positions at current levels. That makes HNZ a prime candidate for a short squeeze. Earnings later this month could be a prime catalyst.
Eaton Corporation (ETN) is a bit unique on our list today. The $17 billion power management firm currently boasts a short interest ratio of 10.6, a number that's probably as high as it is because of the firm's pending acquisition of Cooper Industries (CBE) -- many investors are shorting Eaton as half of a merger arbitrage strategy. But it's important to remember that it doesn't matter why a stock is getting shorted. A high short interest ratio alone is enough of a structural reason to cause a short squeeze.
The Cooper acquisition is a big deal for Eaton. The move stands to double ETN's size and create a lot of cost savings in the combined firm. A big part of the reason why ETN is seeing so much shorting comes from the risk premium that's been priced into shares -- with the spread between Eaton's offer price and Cooper's share price higher than investors are used to seeing, there's been a fat profit to be made for arbitrageurs. But those gains could get eroded when Eaton closes the deal later this year.
That could be an important short squeeze catalyst to watch for in the next couple of months.
Campbell Soup Company
There's no company on today's list that investors hate more than Campbell Soup Company (CPB). With a short interest ratio of 14.1, it would take very close to three weeks of buying at current volume levels for shorts to exit their bets against this stock. But all of that animosity may be misguided.
Campbell has been heavily shorted for a while now, thanks in large part to two big targets: a large dividend payout and hefty exposure to input price inflation. But short theses haven't played out as expected for this stock thus far, and they don't look likely to as CPB slowly shores up its finances. Campbell owns a portfolio of brands that includes Pace, Prego, Swanson and Pepperidge Farm in addition to its namesake label. A renewed focus on international sales has helped to break CPB from its revenue flatline, and even though so-so numbers last quarter sparked more shorts piling into shares, Campbell's next earnings call on November 20 could be a good catalyst.
In the meantime, I think that Campbell looks like a good candidate for a dividend hike in the next quarter. That boosted return should help to eat into shorts' potential profit enough to hike their stop losses higher. From a technical standpoint, if Campbell can take out the glut of sellers at $35.50, it should have much higher ground in store.
Last up is financial data firm Moody's (MCO). As one of the "big three" ratings firms, Moody's controls around 40% of the market for debt ratings, a position that gives the firm ample cross selling opportunities among its user base. But this stock hasn't exactly been well liked over the last few years. Moody's deservedly got a lot of the blame for the financial crisis of 2008, as inflated credit ratings on mortgage-backed securities made investors believe that the bad debt they were buying was much safer than it was. And more recently, Warren Buffett's unceremonious selling of his stake in Moody's has spurred other investors to follow suit.
That's helped push MCO's short interest ratio up to 11.9.
At the end of the day, MCO is still one of the biggest games in town for debt ratings, and cheap credit costs have re-opened the debt issuance spigot worldwide. With interest rates expected to remain low for an extended period, that should remain the case for the foreseeable future.
Credit ratings aren't the firm's only business. The firm also sells research and quantitative databases, products that (like ratings) are capital-light and produce impressive margins. The firm has been shoring up its balance sheet over the last few years, moving from a lot of leverage to a nearly debt-neutral position more recently. That extra wherewithal makes the risks of financial stress much less for the firm, and much more likely to see a short squeeze in the near term.
To see this week's short squeezes in action, check out the of 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.