BALTIMORE (Stockpickr) -- If you want to beat the S&P 500 by double digits in 2014, just focus on the stocks that investors hate the most.
That may sound unintuitive, but hate can be a powerful emotion in the markets. It's powerful because, more often than not, it's wrong. When investors get heated about a stock and a trade gets crowded, there's a often money to be made on the other side of it. (That's one of the tenants of contrarian investing.)
But don't just take my word for it. The data backs it up too.
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. So how do you cash in this month?
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 short sellers who need to cover their losing bets. And with the S&P 500 within grabbing distance of all-time highs, you can probably guess that there are lots of losing open short bets feeling the squeeze right now.
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.
Large-cap health care IT firm Cerner Corporation (CERN) is the biggest name on our list -- the firm tips the scales with a $20 billion market capitalization. But a blue-chip valuation isn't enough to spare the firm from short sellers. With a short interest ratio of 11, it would take two full weeks of buying pressure for short sellers to exit their bets against this stock.
More than a third of U.S. hospitals use Cerner's Millennium platform to store everything from patient medical data to financial records. It's not just hospitals either. From pharmacies to physicians' offices, CERN's software and hardware is found in more than 9,300 medical facilities globally. Cerner's platform makes a lot of sense for health providers. Because of its huge footprint in the industry, transitioning new employees with medical office experience takes less time, and the firm benefits from economies of scale in developing new feature sets.
Another big incentive for facilities is getting paid quicker. Cerner's offerings cut down the administrative steps needed to get practices and hospitals payments from either insurance companies or government programs. That helps lessen the blow of a costly medical IT package. Because use of computerized medical records is now mandated by legislation, Cerner's products are a cost of doing business, not a luxury.
Between secular tailwinds in the medical industry and new pushes into lower-priced options for smaller medical practices, CERN has open runway ahead of it for growth. Look for a possible short squeeze catalyst in earnings next month.
Illumina (ILMN) has been a short seller's worst nightmare in 2014. Since the calendar flipped to January, shares of this $19 billion life science stock have rallied more than 33%. That's compared with a broad market that hasn't even rallied a full point over that same period. Zoom out to the past full year, and Illumina's gain widens to a neck-craning 180%. But none of that has stopped short sellers from betting against ILMN; if anything, it's emboldened them.
With a short interest ratio of 12.58, it would take two and a half weeks of nonstop buying pressure at current volume levels for shorts to get out of their bets on ILMN.
Illumina manufactures tools for genetic analysis, a space that's been growing quickly in the last few years. Best of all, most of Illumina's products are both high-end and consumable -- they're used to collect and analyze genetic material, and then they're discarded. That, in turn, drives recurring revenues at big fat margins. As more commercially successful genetic therapies come to market, it should help to fuel big boosts in genetic R&D spending, and big boosts in orders for Illumina's offerings.
From a financial standpoint, Illumina is in good shape, with $164 million in net cash on its balance sheet. To be clear, this stock is far from cheap. It trades for a whopping 172 times trailing year's earnings right now, and that's a big part of why shorts feel so confident in betting against it. But being short ILMN is such a crowded trade that any hint of positive news could set off a squeeze this quarter.
Investors hate M&T Bank (MTB) right now. There's no other way to explain the hefty short interest ratio of 19.14 in shares right now. At current volume levels, it would take a full month of buying for shorts to cover -- and between one of the industry's bigger dividend payouts and the threat of rising interest rates coming from the Fed right now, short sellers should be feeling pretty uncomfortable heading into the second quarter.
M&T Bank is a regional bank with a more-than-regional footprint. The Buffalo, N.Y.-based firm has more than 750 branches spread along the East Coast and an asset base that makes it one of the country's 20 biggest banks. Like other regionals, stricter underwriting standards helped to limit write-offs in the wake of the real estate bubble, and as a result, the firm had a fraction of the underperforming loans that its big bank peers did.
Regulators have liked MTB's strength from early on -- the fact that the firm got a 2.3% dividend yield approved is evidence of that. If interest rates really do show upward mobility in the intermediate term, so too will the spreads that MTB is able to charge for its services. That's good reason for short sellers to tread lightly in 2014.
Don't accuse Fastenal (FAST) of having an overly-exciting business -- the $14 billion industrial supplier built its business by carrying more than 410,000 different types of fasteners. But the most boring stocks can often be the most lucrative ones, and as the industrial sector heats up, so too do Fastenal's sales.
Fastenal's catalog goes far beyond its namesake fasteners: The firm carries some 585,000 maintenance and repair products in 2,400 retail locations, an inventory and footprint that makes FAST a one-stop shop for its customers. Because of its huge scale, Fastenal can compete on price better than smaller rivals in the fragmented industrial supply industry. And don't think that innovation doesn't exist in this business. New distribution models, such as vending machines in customers' facilities that help better track purchasing, have been a big contributor to Fastenal's year-over-year growth.
Right now, Fastenal's short interest ratio comes in at 17.27. That's a good indication that short sellers are counting on a slowdown in those revenue and profit growth rates. Since 2010, profits are up more than 67%. But being short FAST looks like a crowded trade in March. Look out for earnings on April 11 as a possible squeeze trigger.
Last up is luxury handbag maker Coach (COH), a company that was the poster-child for organic growth in the void of the Great Recession five years ago. Coach has built a business out of hitting the sweet spot between luxury and price, offering customers attainable luxury without diluting its brand vale. That's a tough tightrope to walk (many once-premium brands have failed at it), and the fact that Coach made it to the other side should secure the firm's growth trajectory for years to come.
Coach makes and sells handbags and other accessories (such as wallets and umbrellas) through a network of around 550 North American stores and a large presence online and in third party channels like department stores. Emerging markets have been a huge source of growth more recently, as a burgeoning middle class looks to acquire aspirational brand-name merchandise.
Financials don't get much better than Coach's. The firm carries a nearly $1.3 billion cash and investment position, and no debt. That means that there's enough wherewithal on COH's balance sheet to pay for nearly 10% of the firm's outstanding shares at current price levels. That's a big risk reducer, and it puts the firm's ex-cash P/E down to just 13x earnings -- not a growth stock multiple.
Still, at last count, shorts have piled into COH with a short interest ratio of 10.06.
To see these short squeezes in action, check out this weeks Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.