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Shorts show the way to winning stocks
New data on short selling reveal some surprising market signals that active investors would be wise to heed. Here’s a look at the statistics and what they mean for your portfolio.
By Michael Brush
Many professional investors love to get a sense of what the crowd is doing and then take the opposite bet -- on the somewhat arrogant reasoning that the mob usually gets things wrong. Car? Home? Home equity?
One application.
Up to 4 loan offers.
This often works. But that mob may not really be all that dumb after all, at least when they’re taking giant short positions in a stock as a bet that it will get whacked.
That’s the conclusion of a recent study by Prudential Securities, which shoots holes in the conventional wisdom that big short positions often signal nice gains ahead for a stock.
Investors short stocks by borrowing shares and selling them. They're hoping the stock will sink so they’ll be able to buy it back later at a lower price to close the loan, or “cover the short” in trading jargon. If they win that bet, they pocket the difference.
Unconventional wisdom
Before we get to the most interesting details of the Prudential study, let’s take a quick look at why conventional wisdom contends that a big short interest suggests that a stock is headed up.
First, when too many people have latched on to an investing idea, it’s often a signal that an irrational crowd psychology has set in. Remember the extreme lows of Sept. 21 last year? (Or the highs in technology in March 2000, for that matter.)
Next, once enough investors have jumped on board a trend, there aren’t many left to throw money at the idea -- suggesting it may reverse hard when some news spooks the crowd. Put slightly differently, a huge short position means that if some good news breaks, lots of investors will have to cover and drive the stock up quickly.
Following this kind of reasoning, many money managers actually like to see lots of shorts in a stock when they go long -- especially value investors.
Dangerous game
But they are playing a dangerous game, according to Prudential. Researchers there found that stocks with a big short interest really do typically perform worse than their peer groups. And those with little short interest do better. A lot depends on the size of the company, however, and whether it’s considered a growth or value play.
Here are the basic conclusions from the study that can be useful for traders.
A big short interest works best as a sign of damage to come among small-cap stocks. Those are the ones with a market capitalization between $300 million and $1.5 billion. It’s also a bad omen for mid-cap stocks (between $1.5 billion and $11 billion). But the level of short interest is a bit less effective as an indicator here. For large-cap stocks -- over $11 billion in the Prudential study -- the size of the short position wasn’t a good indicator at all.
Among small-cap stocks, the 20% with the biggest short positions lagged their peer group by 11%, if you annualized losses in the month following the registration of the big short position. But for mid-cap stocks, the shortfall was just 6%. The best-ranked 20% among small caps (those with the smallest short position) outperformed their peers by 11%. But for mid-cap stocks the advantage was around 8%.
It’s no surprise that the level of short interest works better for smaller companies. Lots of quantitative factors -- such as earnings-estimate revisions -- tend to be more effective the lower down you go in terms of market capitalization. Why? For smaller-cap stocks, there tend to be fewer analysts -- on the buy side and sell side -- researching and spreading news around about the stock.
Short interest works better as an indicator for growth stocks than value stocks. Among small caps, for example, poorly ranked growth stocks underperformed by 14%, while badly ranked value stocks lagged by only 6%. On the flip side, highly ranked growth stocks beat their peers by 15%, but value shares with a low short interest did better by just 7%.
The good and the bad
According to Prudential’s study, some of the most vulnerable small-cap companies based on the size of the short position are: EGL Inc. (EAGL, news, msgs) in basic industry; AstroPower (APWR, news, msgs) and Echelon (ELON, news, msgs) in capital goods; and Midway Games (MWY, news, msgs) and Marcus Corp. (MCS, news, msgs) in the consumer non-durables area. Others include: Dril-Quip (DRQ, news, msgs) in energy, Silicon Valley Bancshares (SIVB, news, msgs) in financial services, Enzo Biochem (ENZ, news, msgs) and SurModics (SRDX, news, msgs) in health care, and Coherent (COHR, news, msgs) and Electro Scientific Industries (ESIO, news, msgs) in technology.
The worst-ranked mid-cap stocks include: Fastenal (FAST, news, msgs) and Rainbow Media (RMG, news, msgs) in consumer services, 21st Century Insurance (TW, news, msgs) and Markel (MKL, news, msgs) in financial services, and Herman Miller (MLHR, news, msgs) and National Instruments (NATI, news, msgs) in technology.
The best in the small-cap arena include: American Woodmark (AMWD, news, msgs) in basic industry, Rock-Tenn (RKT, news, msgs) and Ivex (IXX, news, msgs) in packaging, and Watts Industries (WTS, news, msgs) in capital spending. Lots of consumer stocks put in a strong showing, including Dura Automotive Systems (DRRA, news, msgs), Bob Evans Farms (BOBE, news, msgs), Boyd Gaming (BYD, news, msgs), Choice Hotels (CHH, news, msgs), Haverty Furniture (HVT, news, msgs), Jack In the Box (JBX, news, msgs), Zale (ZLC, news, msgs) and Nu Skin Enterprises (NUS, news, msgs). Others include Gold Banc (GLDB, news, msgs) and Stewart Information Services (STC, news, msgs) in financial services, and Bio-Rad Laboratories (BIO, news, msgs) in health care.
Highly ranked mid-cap stocks include: Engelhard (EC, news, msgs) and Praxair (PX, news, msgs) in basic industry, Deluxe Corp. (DLX, news, msgs) in business services and Ambac Financial (ABK, news, msgs). In the consumer area, Darden Restaurants (DRI, news, msgs), Federated Department Stores (FD, news, msgs), Mattel (MAT, news, msgs) and Pepsi Bottling (PBG, news, msgs) score well. So do Becton Dickinson (BDX, news, msgs), DaVita (DVA, news, msgs) and WellPoint Health Network (WLP, news, msgs) in health care, and Mettler-Toledo (MTD, news, msgs) and National Semiconductor (NSM, news, msgs) in technology.
Keep in mind, Prudential’s study took the best and worst stocks ranked by short interest and then looked at the performance only over the following month. This means their results might be more useful in the hands of traders as opposed to longer-term investors.
A little twist
And if you blend in some other factors -- such the movement of a stock’s price -- the level of short interest works just fine as a decent contrarian indicator. That’s the view of Phil Erlanger, a former technical analyst at Fidelity Investments who now uses the level of short interest, among other factors, to rate stocks at his Web site, Erlanger Squeeze Play.
To find stocks that may rise, Erlanger first scans for shares that have big short positions relative to their five-year history. This beats looking at the short position in the absolute sense, because some stocks have a naturally high -- or low -- level of shorts.
Among these stocks, Erlanger then looks for the ones that are outperforming -- or moving against the shorts and making them sweat. At some point, shorts are likely to give up and buy back the stock to get out of losing positions. It’s called a “short squeeze” if they get panicky about it.
“You have to look at the short interest in comparison to what is happing with the price and then make a judgment,” says Erlanger. “I take the guesswork out because I wait for the market to tell me the shorts are wrong.”
Stocks that currently look attractive because they have decent relative strength despite big short positions include: Coca-Cola (KO, news, msgs), 3M (MMM, news, msgs), Philip Morris (MO, news, msgs), Campbell Soup (CPB, news, msgs) and Staples (SPLS, news, msgs); as well as steel companies Cleveland-Cliffs (CLF, news, msgs) and Lone Star Technologies (LSS, news, msgs). Others include truckers Yellow (YELL, news, msgs) and JB Hunt Transport (JBHT, news, msgs), Noble Drilling (NE, news, msgs), prescription benefits manager Express Scripts (ESRX, news, msgs), Ceridian (CEN, news, msgs) in electronic data processing, Harris Corp. (HRS, news, msgs) in diversified electronics, and the pharmaceutical company Baxter International (BAX, news, msgs).
On the other hand, Erlanger also scans for stocks in a downtrend with light short positions. This is a sign investors are too bullish. And it may lead to a “long squeeze” if investors who are long bail out en masse as the stock keeps sinking. The damage may end up being worse because there is no short-covering to support the stock.
Stocks that look like they could head lower because they are sinking and there is little short interest include: General Electric (GE, news, msgs), eBay (EBAY, news, msgs), and AOL Time Warner (AOL, news, msgs); as well as Bristol-Myers Squibb (BMY, news, msgs) and Mylan Laboratories (MYL, news, msgs) in the pharmaceuticals group. Others include Genzyme (GENZ, news, msgs), Human Genome Sciences (HGSI, news, msgs), Sepracor (SEPR, news, msgs) and ImClone Systems (IMCL, news, msgs) in biotechnology; as well as Comverse Technology (CMVT, news, msgs), Flextronics (FLEX, news, msgs), Nvidia (NVDA, news, msgs), Broadcom (BRCM, news, msgs) and Maxim Integrated Products (MXIM, news, msgs) in technology.
If you try this at home, keep in mind that companies with lots of outstanding bonds that can be converted to shares might show a big short position that’s not necessarily a negative, notes Tim Ghriskey, of Ghriskey Capital. It’s just the convertible bondholders hedging against a decline in the stock price while they collect interest.
And remember that a lot more people are shorting many stocks these days simply as a hedge against long positions in similar stocks -- or elsewhere in the market. “It doesn’t mean what it used to mean,” says Larry Hite, of Hite Capital, a New York hedge fund. “The motive is not as stock-specific as it used to be. Sometimes they just want to cut risk.”
At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column.
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