These 5 Stocks Look Primed for a Short Squeeze

These heavily shorted stocks could get squeezed much higher on any positive catalyst.
By Jonas Elmerraji ,

Stocks muscled their way to a second straight day of new all-time highs on Tuesday, with the S&P 500 making its way to gains of 5.4% for the year. At this point, 2016's price appreciation hasn't been outsized, but it has been steady.

On a total returns basis, the S&P 500 is on track to deliver full-year gains of 12.9% if the current pace for stocks continues. Even more impressive is the rally that the S&P has been enjoying since the broad market bottomed back in February. In that five-month stretch, the S&P has managed to move nearly 20% higher once dividends are factored in.

That upward trajectory for stocks has been putting the squeeze on one particular set of market participants: short sellers.

And when short sellers feel the pressure, it's not uncommon to see a short squeeze in some of Wall Street's most hated stocks - in a short squeeze, shares can make explosive upside moves as short sellers get forced to cover their positions by buying back shares, adding fuel to the rally.

History shows that buying the market's most hated big stocks can actually pay off in the long run. Over the last decade, 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.

For our purposes, 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.

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.

O'Reilly Automotive

Leading things off is auto parts store chain O'Reilly Automotive (ORLY) - Get Report . O'Reilly has managed to hand investors some solid performance so far this year. Shares of the $27 billion automotive chain have rallied nearly 9% since the calendar flipped to January, edging out the big stock averages by a meaningful margin.

Along the way, short sellers have been feeling the pressure. So far, short interest in O'Reilly Automotive remains relatively high. At last count, this stock's short interest ratio came in at 10.5.

O'Reilly Automotive is the No. 2 car parts retailer in the country, with 4,571 locations spread from coast to coast. The firm has a dual sales channel, selling both to do-it-yourself consumers as well as professional repair shops. While many peers are playing catch-up on the professional side of the auto parts market, O'Reilly has an established base of pro customers that it's able to sell into.

There are some big macro factors that bode well for the auto parts business right now. For starters, the average car on the road today in the U.S. is older than at any other time in history. Older cars mean more demand for replacement parts, and that trend is only likely to become more prominent as new car sales prices continue to rise and consumers try to wring more life out of their current rides.

Look out for second-quarter earnings at the end of July as a potential upside catalyst.

CarMax

CarMax (KMX) - Get Report  is another heavily shorted automotive stock that's a prime candidate for a short squeeze this summer. CarMax is one of the largest publicly-traded car dealers, with a network of 158 superstore locations that sold more than 619,000 vehicles last year. Unlike most of its peers in the auto dealer space, CarMax is unique in that most of its volume actually comes from used cars, with only about 1% of revenue generated through new car sales. That's a very good thing for the firm's bottom line, with used car margins typically twice as large per unit as the profits made on new cars.

CarMax's inventories skew late-model and low-mileage. Any cars it buys that don't fit that mold never hit a CarMax lot. (Cars that don't fit its sales criteria are sold at auction.) Used cars sold at retail make up 80% of revenue. The balance comes from wholesale cars, service plans, and repairs. By acting as a known intermediary in the used car buying process, CarMax is able to charge a premium over competing dealerships that have less invested in their reputations.

Short sellers have been piling into CarMax in a meaningful way lately. At last count, nearly one in six shares of CarMax's float was being shorted, a stat that makes this used car specialist a prime short squeeze candidate. Shares are already back within grabbing distance of their 2016 highs this summer, and a push above $56 opens up a lot of technical upside potential from here.

Deere 

Agricultural and construction equipment giant Deere (DE) - Get Report  has been a long-term target for short sellers. Today, the firm currently has a short interest ratio of just over 10, signaling that it would take two full weeks of buying pressure at current volume levels for short sellers to exit their bets against Deere. And as shares move back up toward this year's highs, Deere could be a short squeeze candidate worth watching.

Deere is one of the biggest agricultural, construction, turf and forestry equipment manufacturers in the world. Despite making niche industrial products, Deere benefits from household-name status. Even if you've never set foot on a farm, the firm's signature green and yellow logo is unmistakable. That huge brand value also translates into smaller, consumer and prosumer-grade equipment. The firm's bread and butter is still the ag market; all told, Deere owns about half of the North American market for heavy agricultural equipment.

The prolonged decline in commodity prices has been an unmistakable drag on earnings for Deere, but it's finally turning around in 2016, as soft commodities rebound and farmers find themselves in a position again to upgrade their equipment. Like an automaker, Deere owns a captive finance arm, Deere Capital. That finance unit gives the firm the ability to subsidize its finance costs in order to move more equipment. That's a valuable selling tool, and it should only become more useful in the economic environment ahead.

Sprint

No doubt about it, investors hate Sprint  (S) - Get Report . With 26% of this stock's float currently being shorted, market participants clearly have a dim view of the nation's fourth-largest cellular carrier. But that outsized shorting could translate into a short squeeze, even if the firm fails to make any fundamental progress by first quarter earnings at the end of this month.

Sprint provides cellular services to approximately 59 million subscribers, putting it far in trail behind the near-duopoly on mobile service created by AT&T (T) - Get Report  and Verizon (VZ) - Get Report . The cellular business is hugely competitive, and Sprint's significantly smaller size has made it challenging to compete with the huge infrastructure investments that its larger peers are able to make.

To counter that, the firm has focused on customer acquisition through much lower pricing. While Sprint is currently burning through cash to make that growth strategy work, the company has made some important inroads at achieving the critical subscriber mass it needs to become consistently profitable.

One major factor in Sprint's ability to lose money in the near-term for longer-term benefits has been the backing of 81% owner Softbank. Another important contributor to Sprint's value is the considerable spectrum position, which it was able to buy using Softbank's money. If Sprint can show investors some more-palpable progress come earnings time, any hint at higher ground could be enough to send short sellers running.

Realty Income

If there's one thing that's like kryptonite for short sellers, it's dividends. Dividend payouts are hard to swallow for shorts because they're direct contributors to a stock's total returns -- and for high-yield stocks such as real estate investment trusts, they make shorting a risk endeavor as long as the firm keeps producing cash.

That's the case with Realty Income (O) - Get Report  right now. This $18 billion REIT currently pays out a 3.4% yield.

Realty Income is one of the biggest real estate investment trusts on the market. The firm owns approximately 4,500 commercial properties, mainly freestanding retail locations, and it leases those properties to tenants on a triple-net basis. That means tenants, not the firm itself, are responsible for the property taxes, insurance, and maintenance costs at Realty Income's properties. That structure makes Realty Income a purpose-built dividend machine.

Another factor for shorts has been Realty Income's price performance this year. So far, this stock has rallied 35% since the calendar flipped to January, putting the hurt on any investors who've been putting money on the likelihood of a decline. At this point, shorts have been holding onto their positions, pushing Realty Income's short interest ratio to 10.

This is another stock that posts its quarterly results at the end of the month, giving us a nearby catalyst that could trigger a squeeze.

Disclosure: This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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