3 Short-Squeeze Stocks for Earnings Season

Editor's note: As part of our partnership with Nightly Business Report, TheStreet's Bob Walberg appeared on NBR Monday (see video and transcript here) to look at stocks with short-squeeze potential this earnings season.

NEW YORK ( TheStreet) -- Europe's a mess, Chinese growth is slowing down faster than expected, the domestic recovery is in its infancy and we are about to enter a traditionally slow seasonal period for the market. It's no wonder investors are selling stocks. But there's a big difference between selling to lock in gains or to shed a loser and selling short.

Selling short means that an investor borrows stock to sell at today's price, with the intention of buying it back in the future at a lower price. The short investor is betting that the price of the stock in question will decline. However, if the price of the stock should go up instead of down, at some point that investor will be forced to buy back his stock to limit his loss.

Naturally, the more people are forced to cover their positions on the way up, the more the buying pressure will propel the stock higher. This action is what is commonly referred to as a "short squeeze."
Word on the Street

Anticipating a short squeeze can be a very profitable way to play the market, and there is no better time to employ this strategy than during earnings season. Earnings provide a catalyst for action and if the short sellers are proven wrong by a stronger-than-expected quarter, they will start to aggressively cover their positions, thereby triggering the aforementioned squeeze. We have seen such activity play out routinely in stocks such as Lululemon ( LULU), Chipotle Mexican Grill ( CMG), Intuitive Surgical ( ISRG), etc.

Admittedly, stocks are often shorted for good reason -- management issues, accounting irregularities, hyper-valuations. Nevertheless, if you can identify a candidate that defies the skeptics, the surge to new heights can prove very, very rewarding. Just look at the charts of the three examples cited above.

When looking for short-squeeze candidates, you first want to find stocks that are very heavily shorted. You can find this data relatively easily on popular free investing sites such as TheStreet or Yahoo! Finance. Then you want to find stocks that are either in the early stages of growth -- where upside sales or earnings surprises are common -- or at rock-bottom -- where the selling is pretty much exhausted, and even bad news doesn't have the desired downside impact.

Looking at the current list of heavily shorted stocks, three names jump out at me as being good candidates for a short-squeeze rally: Skullcandy, DreamWorks Animation SKG and KB Home.

Skullcandy ( SKUL) develops and distributes headphones and other audio accessories to retailers in the United States and to distributors internationally. This is a basic, easy-to-understand business -- I like those because it's easier for me to conceptualize how they operate than, say, a biotechnology company -- that is experiencing rapid growth with the explosion of smartphones, iPods and iPads.

The company is due to report earnings on May 7. Revenues are projected to jump by 24% in FY2012. With 125% of the stock's float (shares available to the public) being shorted, if the company provides any upside surprise this stock is poised for an explosive rally fueled by short-covering. A retest of the all-time high of $23.40 is probable, with a break above that level leading to a runaway rally.

DreamWorks Animation SKG ( DWA) engages in the development, production and exploitation of animated films and associated characters worldwide primarily for the theatrical, home entertainment, television, merchandising and licensing markets. It has approximately 23 animated feature films, including the popular Shrek and Madagascar franchises.

This is an example of an older company that is deeply oversold. It's doubtful to me that even bad news could sink this stock much further. And the news around this company is set to improve.

In addition to a new Madagascar film due out in June, DreamWorks recently signed a deal with China that has long-term promise. The company also plans to ramp up its production schedule in coming years to make sure it releases a minimum of three major motion pictures in any given year. These developments point to improved momentum for the business, and that should be bad news for short sellers. About 29% of the outstanding float is currently held short. Our price target is the $22-$23 area.

Finally, take a look at KB Home ( KBH). Much like DreamWorks, KBH is a stock that was sold hard during the previous three years. If you wanted out of home construction stocks -- and pretty much everyone did -- you got out during this period. The stock enjoyed a nice rally earlier this year, but it has sold off hard since and is now trading just below its 200-day moving average.

Though the housing sector isn't poised for explosive growth this year, one look around your own neighborhood will tell you that the situation is ripe for new construction again. Inventory is drying up in most areas. Consequently, the news out of this sector and this company will offer more positive than negative surprises, and with over 62% of the float being shorted, KBH makes a decent candidate for a short-squeeze. My price target is $10.50.

>>To see these stocks in action, visit the 3 Short-Squeeze Stocks for Earnings Season portfolio on Stockpickr.

Robert Walberg is chief market strategist and editor of Premium Products at TheStreet. Prior to joining TheStreet, Walberg was founder and president of Chartwell Asset Management, a financial advisory company. Before founding Chartwell, he worked as a financial analyst and columnist for MSN Money from 2003 to 2008. Walberg was on the founding team at Briefing.com from 1996 to 2003, working as chief equity analyst, formulating the company's near-, intermediate- and long-term market positions. He was regularly quoted by The Wall Street Journal, Bloomberg, Reuters and Investor's Business Daily and made guest appearances on Fox Business, CNBC, CNN, ABC World News and The Daily Show with Jon Stewart. Walberg received a bachelor's degree in political science from the University of Illinois.