BALTIMORE (Stockpickr) -- Investors are feeling a lot of hate in 2014.
To hear the hand wringing on Wall Street this month, you'd think the 4% correction in the S&P 500 since the calendar flipped to January was actually closer to 40%. After a yearlong love affair with stocks, we suddenly hate them again.
But what if you could harness all of that hate for gains in 2014? Well, the data show you can.
Hate is a powerful emotion in the markets. It's powerful because, more often than not, it's wrong. 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. 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. Too much hate can spur a short squeeze, a buying frenzy that's triggered by shorts who need to cover their losing bets. And with the rally we've been since late 2012, you can probably guess that there are lots of losing open short bets.
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.
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 the months ahead.
One of the most perennially hated names of the last year has been Salesforce.com (CRM - Get Report) -- and all the while it's continued to shove its way higher. In the last 12 months, Salesforce has rallied 33.35%, a full 15.3 percentage points more than the S&P has managed to run over the same period. But with a short interest ratio of 11.43, it would take more than two full weeks of buying for shorts to cover their bets right now.
Salesforce.com builds a software product that enables 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.
But big investments in growth have given CRM a steep price tag by conventional measures. And that's what's spurred shorts to position themselves against this stock. Never mind the fact that customers have huge switching costs, or that cutting back on some of those big growth costs could increase profitability quickly (if nominally).
Salesforce's fourth-quarter earnings release next month could be the catalyst for a pop.
$15 billion regional banking name M&T Bank (MTB - Get Report) is another name that's ranked high on investors' hate list for the last year. And the firm's short interest ratio of 11.82 indicates that shorts are still actively in this name.
M&T Bank is one of the big regional banking names that shone during the financial crisis of 2008. By actually sticking to retail and commercial banking in the fat years leading up to the real estate crash, M&T had the stronger underwriting standards it needed to make it though the lean years. While a regulatory edict to improve risk management has got short sellers salivating, the opportunity is overblown, especially considering the wider margins and cheaper valuation that MTB sports relative to its "big four" peers.
With a 2.5% dividend yield, M&T has been one of the better income options in the banking industry. Regulators are stingy about letting banks pay cash to shareholders, so the dividend is an important vote of confidence from some of the people who know M&T's financials most intimately. MTB is a crowded name for shorts right now.
Green Mountain Coffee Roasters
If there's ever been a poster-boy for short squeezes, it's Green Mountain Coffee Roasters (GMCR). Not only is the specialty coffee stock up more than 65% in the last 12 months, the shorts have also jumped back in at every pause along the way. GMCR's current short interest ratio of 14.36 means that it would take short sellers nearly three weeks to cover their bets at current volume levels.
Green Mountain owns Keurig, the brand of beverage brewers that use self-contained K-Cups to make coffee, teas, and other drinks. K-Cups offer a sticky revenue stream for Green Mountain. Because they're proprietary, the firm can command premium pricing for them. And because the firm can offer new, diverse drink choices (such as hot cocoa or iced coffee), it's able to drive sales among its large base.
Shorts argue that Keurig is a fad -- and they may be right. But as an investor, I want to own the fad stocks. They're the ones that get to ring the register the most. Numerous major (non-fad) competitors have tried to unseat Keurig's leading position in the single-brew coffee business. So far, it hasn't worked which is why next week's earnings could be a squeeze catalyst for GMCR.
Dividends are like kryptonite to short sellers. That's why it's interesting that shorts are barricading themselves in shares of Realty Income (O - Get Report), the real estate investment trust known to its investors as "the monthly dividend company." At last count, Realty Income has a short interest ratio of 15.97.
In many ways, Realty Income is a prototypical REIT. It may seem surprising to some, but REITs actually act a lot more like fixed income instruments than real estate investments. That's because the firm leases properties to tenants using long-term triple net leases, which give the firm consistent, predictable income growth without needing to worry about variables such as maintenance, property taxes or insurance -- tenants are responsible for those costs. Realty Income's mature portfolio of 3,800 well located mostly single-tenant retail properties gives it some downside protection against economic hiccups.
Right now, Realty Income pays out a 5.4% dividend yield. That's significant from a shorting standpoint because dividends are a direct way that firms can impact the value of their shares. Even in a flat market, dividends and margin interest can eat away at short returns -- and prime the pump for a squeeze.
Security and automation firm ADT (ADT - Get Report) is one name that's actually panned out for shorts in the last year. Shares have dropped 20% in the trailing 12 months, lagging the broad market's performance by a wide margin. But as ADT gets used to its status as a standalone company, it's giving shorts a reason to cover and take gains while they can.
Right now, ADT has a short interest ratio of 13.56. That's almost three straight weeks of buying pressure if short sellers need to cover quickly.
ADT provides burglary, fire and carbon monoxide monitoring as well as home automation services for more than 6.4 million customers in the U.S. and Canada. That's good enough to make up a full 25% of the residential and small business security market. Because ADT's customers sign lucrative, relatively long-term contracts to add ADT's services, multi-year retention rates are extremely high. And because customers go to the trouble (and expense) of installing ADT hardware on their premises, switching costs are even higher.
The addition of the Pulse platform adds value for customers who have ADT system installed. The product enables features such as automation that integrate directly with ADT's security infrastructure. Better, it provides a lucrative stream of added services that it can market to its huge rolodex of customers.
According to our model, this heavily shorted $7.6 billion name has squeeze potential this month.
To see these short squeezes in action, check out this week's Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.