BALTIMORE (Stockpickr) -- The past month and a half has been a good time to be a short seller. As the biggest momentum names on the market roll over, they're leaving some big losses in their wakes. But things aren't as bad as they seem for investors; they're actually worse.
That's because the S&P 500's sideways grind greatly overstates how well stocks are doing in 2014. Since January, the big index is flat, but the average S&P component is actually down 7%.
But I'm not arguing that you should bet against stocks this week. Quite the contrary, in fact.
Being short stocks is a crowded trade. Short interest for U.S. stocks has risen more than 7.5% year-to-date, and short bets are now at the highest levels we've seen since 2009. Every short interest extreme in the last five years has been a spectacular opportunity to buy stocks again -- but the best upside comes from buying the names that short sellers hate the most.
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.
First up is Clorox (CLX), one of the most overbought momentum names of the last few years -- or, rather, one of the most boring valuation-driven blue chips on the NYSE. CLX is the polar opposite of the once-high-flying names that have gotten punished the hardest in 2014, yet it remains hated by short sellers as I write. CLX's short interest ratio currently weighs in at 12.91, indicating that it would take nearly three weeks of nonstop buying pressure at current volume levels for shorts to cover their bets.
Clorox may lack the scale of its much bigger peers, but a speculative name this isn't. The firm has a 100-year history as one of the world's leading household product makers. Clorox's brand portfolio includes big names such as Glad, Hidden Valley and Burt's Bees, in addition to its namesake label. That makes for a very diversified income statement, with sales spread across a large number of categories.
One of Clorox's biggest opportunities comes from abroad, where the firm only earns around 20% of its sales. That underexposure to overseas markets means that there's still a lot of low-hanging fruit for CLX to grab, as long as it continues to prioritize brand spending abroad. At the very least, the fact that around two-thirds of that overseas revenue comes from emerging markets is promising.
The short case against CLX looks overblown. Look for a squeeze opportunity in this stock.
Garmin (GRMN), on the other hand, has been a momentum name this past year. In the trailing 12 months, shares of GRMN have rallied more than 69%, buoyed by a dirt-cheap valuation and significant product growth. So it's not hard to see why short sellers have ramped up this stock's short ratio to 17.08. But, the thing is, even after rallying hard for more than a year, Garmin still looks cheap in 2014.
Just to be clear, I'm talking my book here: I own Garmin. A big reason why is that investors (shorts in particular) have failed to "get" this stock. While shorts focus on the fact that GRMN's car navigation units are becoming commoditized, Garmin keeps innovating its way to new unique products. The aviation and fitness categories are two perfect examples of places where GRMN owns a deep moat. Best of all, the big R&D dollars it spends developing $50,000-per-unit avionics can flow down to its lowest-common-denominator automotive GPS business at minimal cost. So since Garmin's high-end operations pay for themselves, it can squeeze bigger margins out of its efforts.
And Garmin is cheap right now. The firm trades for a P/E multiple of 18, but its balance sheet includes a cash and investments position of $2.8 billion with no debt. That effectively covers 24% of Garmin's current market capitalization, and brings the firm's ex-cash P/E down to a bargain-priced 13.5.
Coupled with big short squeeze potential in April, GRMN continues to look very attractive. At current levels, it would take almost a month of buying for shorts to exit their bets against Garmin.
Short sellers hate Hasbro (HAS) right now too. The $7.3 billion toymaker currently sports a short interest ratio of 12.3, an indication that shorts are stacked deep against the company behind brands such as Transformers, My Little Pony and G.I. Joe.
Hasbro is leveraging strong relationships with movie and TV studios to sell toys. Beyond big-budget feature film franchises like Transformers, the firm's TV joint venture The Hub is an outlet for series that cater to the in-demand children's video market. The connections between entertainment and toy sales are impossible to ignore -- and it certainly beats the conventional sales model of paying to advertise elsewhere. Licensing other brands is another important source of revenues for HAS: the firm's licenses include names like Star Wars and Marvel, and its scale ensures that it's able to offer more to new potential partners than smaller peers.
Financially, HAS continues to be a stellar name. The firm maintains a debt-neutral balance sheet as well as a hefty 3.15% dividend yield that's made HAS a popular name for income investors in the last few years. Look for earnings on April 21 as a potential short squeeze catalyst.
Digital Realty Trust
Short sellers are probably feeling pretty good about Digital Realty Trust (DLR). In the last year, shares of the $7 billion real estate investment trust have fallen 21%, underperforming the broad market by a big margin, and fueling big gains for patient shorts. But hubris is getting the best of the short sellers left in DLR right now. Here's why:
Digital Realty is a REIT with a technology focus. The firm owns more than 100 datacenters, internet gateways, and manufacturing facilities, comprising more than 16.8 million square feet of leasable space. Because demand for datacenter capacity continues to grow (as technology like cloud computing becomes more and more popular), DLR has an added demand factor that most other landlord REITs simply don't. But don't think of this stock like a play on real estate. At its core, like other REITs, it's an income-generation tool.
DLR enters into long-term triple-net leases with tenants, an arrangement that takes most of the risks off of DLR's balance sheet and puts the onus on tenants instead. The result is a predictable income stream and a hefty 6.19% dividend yield right now. That dividend is like kryptonite for short sellers -- it grinds away at their profitability no matter what DLR's price action is doing. That adds to the squeeze potential of Digital Realty in the next few months.
Last up is asset manager Legg Mason (LM), a name that's been in rally mode for the last year. Since April 2013, Legg has rallied more than 48%. That's not a wholly unpredictable bet, considering the fact that asset managers are basically leveraged bets on the stock market. So with the primary uptrend in the S&P still intact in 2014, LM has a lot of upside ahead of it once this correction reverses course.
Legg Mason managed more than $694 billion in assets spread across equity, fixed income, and money market funds. Fixed income is the biggest single asset class that LM owns at 52% of assets, an allocation that's put LM on the right side of a very long-term trend. Prescient management has kept Legg Mason head of its benchmarks in recent years (despite a pretty horrific 2008, that is), and as sideline cash looks for a place to go, Legg has done a good job of attracting inflows.
In a rising market environment, Legg's AUM should continue to rise, which means that its management fees will too. That's the thing that makes this financial firm ebb and flow with the broad market -- and it should continue to be a major factor in upside for this stock. With a short interest ratio of 10.14 right now, it would take short sellers two weeks to get out of their LM bets.
To see these short squeezes in action, check out this weeks Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.