Beat the S&P With 5 Stocks Everyone Else Hates

BALTIMORE ( Stockpickr) -- 2013's market climb has earned the moniker of the "most hated stock rally" -- and for good reason. Since stocks started their latest uptrend in November, sentiment has been pointed markedly away from U.S. stocks. But betting on the rally that everyone hated has paid off: the S&P 500 is up more than 14% year-to-date.

That same approach works well with the market's most hated individual stocks right now too.

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That's not just my opinion -- the data bears it out. Going back over the last decade, buying 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. That's some material outperformance during a decade when decent returns were very hard to come by.

When I say that investors "hate" a stock, I'm talking about its short interest. A stock with a high level of shorting indicates that there are a lot of people willing to bet on a decline in its share price -- and not many willing to buy. 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.

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It's worth noting, though, that market cap matters a lot. Short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same method was used.

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 2013.

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It's been a rough year for ( CRM). While the broad market is up double-digits since the calendar flipped over to January, Salesforce is actually down 10% over the same time period. That's helped to add confidence to short sellers of the $22 billion technology firm, shoving CRM's short interest ratio up to 11.47. That means that at current volume levels, it would take more than two weeks of buying pressure for shorts to cover their positions.

>>4 Big Tech Stocks on Traders' Radars's marquee product enables its 100,000-plus customers to run business applications that interact with their customer lists, doing everything from sending newsletters to tracking sales. That mission-critical nature of Salesforce's offering digs a big economic moat. So does the firm's position as one of the first major business application vendors to focus on the cloud. By pioneering the software-as-a-service model, the firm has a major lead on new rivals that are trying to enter the lucrative hosted CRM software market.

A cloud computing focus also gives the firm a sticky recurring revenue base from customers who have considerable resources invested into the firm's platform. The level of integration that Salesforce provides means that customer switching costs are very high. While CRM boasts an attractive balance sheet, it's struggled with profitability in recent quarters. That will have to change if it wants to show investors that it's serious about returning value to them. In the meantime, Salesforce remains in growth-mode -- and continued stair-step revenue increases should be a scary sight for short sellers.

I'd recommend keeping an eye out for earnings surprise when the firm announces second-quarter numbers in August.

Waste Management

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Short sellers think that Waste Management ( WM) is a garbage stock -- and while they're right in the literal sense, they're betting big against a name that rife with short seller kryptonite: dividends. Dividend payouts are poison to short sellers because they automatically decrease their returns, and because they're the only investment return number that's directly up to the companies that pay them out. WM's 3.5% yield tips the scales right now.

And that high payout makes the firm's short interest ratio look even higher at 10.37.

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Waste Management is the largest waste services firm in the country, with around 270 landfills and a massive fleet of vehicles that spans the U.S. The firm also owns 22 waste-to-energy plants that are designed to turn the waste that WM literally gets paid to collect into renewable energy that the firm gets paid for again. Garbage has a reputation for being a recession-proof business -- and while that's not exactly true (garbage volumes do suffer when the economy is in recession), it's more than fair to say that garbage collection in recession resistant. That defensive bent makes WM look all the more attractive as the broad market pulls back from all-time highs.

Size matters in the garbage collection business. That makes WM's unmatched scale a huge advantage, particularly in negotiating national corporate accounts, or in bidding the most efficiently (since it can spread major fixed costs like landfills across more operations). High levels of profitability and slowly growing sales make WM a prime short squeeze candidate in 2013.


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AutoZone ( AZO) is enjoying a strong year in 2013. Shares of the auto parts retailer have more or less matched the market, but record profitability continues to pile onto the fundamental argument behind shares. AZO owns a network of more than 4,600 stores here in the U.S., and another 321 in Mexico, making it the largest aftermarket car part seller in North America. That hasn't saved AZO from a short interest ratio of 10.38.

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Autozone has enjoyed some big economic tailwinds in recent years. As I write, the average car on the road is older than it's ever been before, and an aging national car fleet is fuelling more car part sales as consumers try to extend the lives of their vehicles. The firm's business isn't relegated to Do-It-Yourselfers -- AutoZone also boasts more than 3,000 commercial locations in its retail stores, providing parts for repair shops and service stations. Obviously, margins on the commercial side of the business don't match the profitability that AZO enjoys on the retail side, but volumes help make up for the shortfall.

Success in Mexico has been another welcome tailwind. As with the U.S., Mexican cars are expected to last longer than ever before, and aftermarket parts are enjoying strong demand. More importantly, a presence in Mexico opens up the possibility for more locations in the lucrative Latin American market -- and the firm's entrée into Brazil is a big next step. Once Latin American operations mature, it could mean leaps and bounds for AZO's financial performance, but a short squeeze isn't likely to take that long.


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Outsourced HR firm Paychex ( PAYX) provides small and medium-sized businesses with payroll and more specialized HR services -- working with around 550,000 clients in all. Paychex benefits from the complexity and administrative burden of payroll processing. Because of the bevy of tax and compliance issues involved in a small business paying its people, the firm is able to earn profits for its expertise. That gives PAYX a role that isn't easily replicated, but that also requires very limited capital to operate in.

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The firm has expanded that role in recent years, pulling out its massive customer rolodex to offer other ancillary HR services such as 401k management and worker's comp insurance. Adding new services onto its menu gives Paychex another big revenue driver from its existing client base, without the economic pressures of the job market. Historically, Paychex has earned considerable profits from its float portfolio -- the huge amount of cash it holds between the time employers deposit it and employees cash their paychecks. While extremely low interest rates have hurt PAYX's float income, there's a huge revenue stream waiting to be unlocked when rates perk back up.

Jobs numbers continue to be a black cloud over Paycheck. Because the firm's business is dependent on employment, the prolonged high levels of unemployment we've encountered since the Great Recession have piled up bets against it -- and pushed PAYX's short interest ratio up to 10.35. That makes this large-cap stock a short squeeze candidate.


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Last up is IntercontinentalExchange ( ICE), a firm that's been making some big moves after it announced plans to acquire NYSE Euronext ( NYX), the parent of the New York Stock Exchange. Until now, ICE's business has been a lot more niche-focused: in total, it operates one of the largest exchanges for over the counter derivatives, or as I like to call them "less commoditized commodities". That nuanced core business gives ICE some attractive opportunities -- it doesn't compete quite as vigorously for trading flow on its platform, and it collects bigger profits as a result.

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The firm's clearing business adds onto IntercontinentalExchange's profit-making abilities. It essentially lets ICE fill a role that a third-party would normally take, and that vertical integration makes the firm much more attractive for investors. Because energy and agriculture are big markets for the firm (and its biggest customers are commercial hedgers), it's less impacted by lower trading volumes in a challenging market. Firms need to hedge their commodity risks in good times and in bad ones.

Right now, IntercontinentalExchange sports a short interest ratio of 16.9. At that rate, it would take more than three weeks of buying pressure for short sellers to cover their bets against the company. While it's fair to say that a lot of that shorting comes from merger arbitrageurs, the reason for the short bets don't really matter -- a short squeeze could still happen if they try to close their positions in one fell swoop.

To see these short squeezes in action, check out this week's Short Squeezes portfolio on Stockpickr.

-- Written by Jonas Elmerraji in Baltimore.


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At the time of publication, author had no positions in stocks mentioned.

Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.

Follow Jonas on Twitter @JonasElmerraji