Stock-Picking Week 5: How to Play Hyped and Shorted Stocks

Mind the hype and monitor the shorts. Those two steps can save you a lot of money in the market. Here's how.
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Editor's note: The Stock-Picking Training Program is a series of six weekly assignments. To start with Week 1, click here. Each assignment is based on one of Jim Cramer's lessons in his book, Jim Cramer's Mad Money: Watch TV, Get Rich. To learn how to get a copy of the book for free, click here.

This week, you will focus on identifying stocks that an existing shareholder should sell. Your objective: Mind the hype and monitor the shorts.

A stock that is hyped by many active traders often has a lot of people that short it (or bet against it) as well (see

"A Short Look at Shorts"). While this is an extension of

last week's assignment, it's worth noting that independent

analyst coverage by itself, does not equal hype.

Rather, hype can come from a place like an online stock message board, where it's easy for someone to discuss "facts" about a company that may or may not be necessarily true (see

"Don't Invest Time in Stock Message Boards"). Hype can also include celebrity endorsements.

In the case of the latter, a recent example of a heavily hyped, heavily shorted stock is

NutriSystem

(NTRI) - Get Report

. In July 2006, when the diet-food maker's stock was up around $65, National Football League Hall of Fame quarterback Dan Marino came on Jim Cramer's television show as the company's newest spokesman.

Around the time of Marino's appearance, Wall Street loved NutriSystem, as it had been trading in the single-digits just the previous spring, but based on a

price-earnings

growth ratio basis (see

last week's assignment), Cramer saw that the stock had already started to look expensive (To learn more about growth rates, check out

"Booyah Breakdown: Grasping Growth").

By doing some more homework on the company, Cramer also discovered that almost 27% of NutriSystem's shares were being shorted and that the company's direct sales business model had already likely seen its peak growth.

With that in mind, despite the incessant hype of faithful traders, Cramer was not surprised to see NutriSystem fall 31% in the next three weeks.

Two other examples of this market pattern that you may remember from recent years are

Taser

(TASR)

and

Travelzoo

(TZOO) - Get Report

.

While

short interest is published by the

exchanges on a monthly basis, it's not as easy to quantify hype (or extreme praise). However, if a company is truly being hyped, it will be difficult to escape the noise.

Now, here is your fifth stock-picking assignment: Build a Stockpickr "sell" portfolio of five stocks with equally high levels of hype and short interest.

Step 1

. Review the "Most Active" lists on most financial portals as well as the

"Biggest % Gainers"

on Stockpickr. Look for the names you don't recognize.

You can also check for the most popular stocks on Stockpickr's

Forum

and

Blog

.

The stock message boards on Yahoo! Finance are a good source of hype as well.

As you navigate this information, take note of the stocks you feel are being hyped.

Step 2

. For each hyped stock that you have identified, look up its short interest (see

"How Do I Find Short Interest for a Stock?"). Cramer considers any short interest over 10% as high.

Step 3

. On

Stockpickr

, build a portfolio of five stocks based on your research. Title your portfolio "Hype/Short:

Your Stockpickr Username."

For each stock, enter your findings in the "Reason For Picking" box.

(To create a portfolio on Stockpickr, you'll need to first login. If you're currently not a Stockpickr member, you can register at

www.stockpickr.com/register

.)

Step 4

. Search Stockpickr for other portfolios that include the term "hype" or "active." Review the reasons for the stock picks and, based on the short interest, post your comments (see "Add Your Comments" in the right-hand column of each portfolio screen) on whether the stocks look like they're about to fall.

Remember, where there's smoke there's fire. If the

fundamentals are not there to support a stock's hype, then the shorts will ultimately win out against the hype-artists.

Editor's note: To learn more about the lesson that this assignment is based on, check out "A Selling Formula."

Next: Stock-Picking Week 6: How to Identify a Sector That's Slowing Down