Call it the bull market nobody liked.
Even as the big S&P 500 index elbows its way to new all-time highs this month, there's more than a healthy amount of skepticism about stocks right now. Experts and amateurs alike have been watching closely for a top in the stock market in 2017. But the top-calling isn't new here. In fact, Total U.S. Short Interest, a measure of total active bets against U.S. stocks, has been at elevated levels since the middle of 2014.
Put simply, on the whole, investors feel uneasy about this market right now. And they hate a big subset of the stocks in it.
The good news is that you can harness that hate for upside opportunities in 2017. When I talk about "hate" here, I'm talking about short interest. The more short interest, the more investors hate a given stock -- enough to actively bet on a decline in its share price. And when shorting becomes a crowded trade, it can create a market phenomenon called a "short squeeze."
The stats show that being contrarian pays off in big, hated stocks. 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.
In other words, the largest massively shorted stocks are actually more likely to squeeze higher than to drop.
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 three 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.
Leading off our list today is $36 billion tech firm VMware (VMW) - Get Report. VMware has been a notable outperformer so far this year. Since the calendar flipped to January, VMware has rallied almost 13% higher, nearly doubling the performance of the big market averages over that same time frame. That's been frustrating for the short sellers hold up in this stock. As I write, nearly 30% of VMware's float is being shorted, a fact that makes it a clear-cut short squeeze candidate in 2017.
VMware is one of the biggest providers of virtualization software, a tool that's becoming increasingly important as computing moves to the cloud. VMware's products enable customers to turn a single physical computer into multiple virtual machines, enabling data centers to offer more hosts without shelling out (or finding space) for new physical servers, for example. The firm is also finding growth in desktop virtualization, where business users are turning to virtual machines to access tools and files sitting on another physical machine.
VMware's bread and butter is still the data center, however, and the firm owns an estimated 80% market share in virtualized data center environments.
Financially, VMware is in stellar shape. The firm boasts nearly $8 billion in cash with just $1.5 billion in debt on its balance sheet. That $6.5 billion net cash position works out to about 18% of VMware's current market capitalization today, a big risk reducer that makes the firm's valuation look much less frothy than it otherwise might at first glance. Buyers are clearly in control of the price action this winter, and that, plus a huge level of shorting, makes this stock a squeeze candidate.
All eyes are on health care this week, following the release of House Republicans' plan to replace the Affordable Care Act. Regardless of how the next political health care volley plays out, Intuitive Surgical (ISRG) - Get Reportstands to benefit from broad, long-term demographic shifts. Intuitive makes robotic surgical systems for hospitals that want to be able to perform less-invasive surgeries than would not be possible if done by a surgeon's hand.
The firm's da Vinci system is currently deployed in more than 3,600 hospitals around the globe -- and that huge installed base comes with some big benefits. Besides the systems themselves, Intuitive also generates revenues selling surgical tools and service contracts for its da Vinci platform, a razor-and-blade model that gives Intuitive massive recurring revenues. Services and instruments and accessories made up more than 70% of Intuitive's revenue in 2016.
By being first to market, Intuitive has more devices in the field than any other minimally invasive surgery platform. As a result, more surgeons are trained to use the da Vinci, a fact that creates a virtuous cycle for Intuitive Surgical. Demographics are aging in developed markets, pushing surgical demand higher in the years ahead. That bodes well for Intuitive regardless of who's paying for the operations.
Meanwhile, short interest remains high in this stock right now. With a short interest ratio of 10.76, it would take more than two weeks of nonstop buying for short sellers to exit this stock.
Short sellers are already feeling the squeeze in shares of $12 billion auto retailer CarMax (KMX) - Get Report. Since November, this stock has rallied more than 31%, leaving the rest of the broad market in its dust. That performance has been pummeling short sellers, who've bid up this stock's short interest ratio to 11.66 -- and it gives shares more squeeze potential in 2017.
CarMax took a relatively low-moat business, used car sales, and built a moat around it. Today, the firm is one of the biggest car dealership operations in the world, with a network of 158 superstore locations that sold more than 619,000 vehicles last year. 99% of those cars sold were used cars, which carry approximately double the average profit margin for the dealership as a new car. CarMax acts as a trusted intermediary in the car-buying process, sniffing out well-kept late-model and low-mileage used cars, and collecting a premium over local used car dealers whose reputations (and financial willingness to correct issues) may not be as sterling as CarMax's.
Scale adds another important advantage for CarMax: financing and service contracts. The firm owns its own captive finance arm, CarMax Auto Finance, which ultimately financed more than 40% of the firm's car sales last year. That extra profit center makes CarMax an attractive stock, particularly as new car prices trend higher and consumers look for alternatives to the nearly $27,000 average new car price paid today.
Look for earnings early next month as a possible short squeeze catalyst in CarMax.
This article is commentary by an independent contributor. At the time of publication, the author held no position in the stocks mentioned.