BALTIMORE (Stockpickr) -- If you want to outperform the S&P 500 this year, all you need to do is love the stocks that everyone hates.
No, that's not an exercise in being contrarian for contrarian's sake. The fact is, hate is a powerful emotion to hone in on in the markets. It's powerful because, more often than not, it's wrong.
And there's a lot of hate in the broad market right now. Despite (or perhaps because of) a 5.5% year-to-date climb in the S&P, short interest for the total U.S. market has rocketed to the highest levels we've seen since 2009. But it's the individually hated names that pack the most upside potential right now. Don't take my word for it -- the data bear it out as well.
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.
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.
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.
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.
Investors hate $40 billion software firm VMware (VMW) right now. Which is problematic for shorts, considering the fact that this stock has dramatically outperformed the broad market over the past 12 months. Since last summer, VMW is up 38.4%, versus a 22.4% climb from the S&P 500. And with a mountain-high short interest ratio of 19.44, it would take a full month of buying pressure for shorts to cover their bets at current volume levels.
That makes VMW a textbook short squeeze opportunity to watch this week.
VMware is one of the biggest vendors of virtualization solutions that help companies get more utility out of their existing physical machines. The firms tools are used to transform a single physical PC into multiple virtual machines, enabling data centers to offer more hosts without shelling out (or finding space) for new physical servers. With the demand for cloud services that weve seen in the last several years, thats a good side of the trend to be on. But VMW's current price tag (and 40 times earnings multiple) reflects that investor optimism -- and that's a big part of why shorts are piled into shares.
No, VMW may not be a bargain, but it does boast a $5.1 billion net cash position on its balance sheet and a fast-growing desktop virtualization business. While there's no shortage of competition in this space right now, VMware has demonstrated that it's able to keep performing fundamentally. Look for earnings at the end of July as a potential short-squeeze catalyst.
Drug maker Actavis (ACT) is another large-cap name on investors' hate list: the $38 billion stock tips the scales in as the third-largest generic pharmaceutical company in the world, a lucrative corner of an industry that's been weighed down by patent expirations. While those expirations are big black clouds for most drug makers, they're enabling ACT to bring new products to market.
Some big M&A deals at Actavis over the last few years have transformed the firm into a much bigger entity. The pending acquisition of Forest Laboratories (FRX), expected to complete in the next couple of weeks, is the biggest one yet. Growth by acquisition has done a good job of increasing Actavis' exposure to overseas markets (which now contribute 40% of the firm's generic drug sales). Likewise, the purchase of Warner Chilcott last year contributed to the firm's branded drug business, which diversifies the generic portfolio and gives the firm claim to bigger margins.
Right now, investors hate Actavis. With a short interest ratio of 10.76, it would take more than two full weeks of buying pressure for shorts to cover their positions. Shares of ACT are pressing up near all-time highs this month a breakout above $230 could trigger a short squeeze.
Alliance Data Systems
Alliance Data Systems (ADS) is all about managing relationships. The firm provides marketing and loyalty services for other companies, handling more than 120 million customer relationships with a specific focus on Canada, where its Air Miles subsidiary operates. So there's a certain amount of irony that ADS has a terrible relationship with Wall Street. Investors hate this stock right now. At last count, ADS sports a short interest ratio of 13.49.
Alliance operates a mission critical business for its customers. Because ADS' loyalty programs are turnkey, they're easily added to a client's offerings, but they're also incredibly sticky. With clients' customer lists and very long-term contracts as standard, revenues are safer than they would be if ADS didn't own many of the networks that it administers for firms. ADS is also a major name in the private-label credit card business, processing transactions on behalf of retailers who don't want the hassle or balance sheet risks of issuing cards themselves (for its part, ADS securitizes its receivables, so little credit risk remains on its balance sheet).
A focus on bringing its loyalty expertise to emerging markets is bearing fruit in 2014. Brazil is a perfect example of a country with a powerful consumer sector where ADS is exposed to meaningful market growth. Earnings at the end of next month could be the next big short squeeze catalyst in this stock.
Economic news has taken its toll on shares of Paychex (PAYX) in 2014; since the calendar flipped to January, shares of the $15 billion outsourced human resources firm have dropped nearly 9%. Since PAYX is tied to the health of the jobs market, the threat of softening jobs numbers in 2014 is luring short sellers to bet against this stock. As it stands, Paychex currently has a short interest ratio of 10.88.
But the argument for betting against PAYX could take a turn for the worse as soon as next week's earnings call.
Paychex provides small and medium-sized businesses with payroll and more specialized HR services, working with around 550,000 clients in all. The firm simplifies the administrative complexities and government paperwork of payroll, collecting fees in exchange for its expertise. The firm has expanded that role in recent years, pulling out its massive customer rolodex to offer other ancillary HR services such as 401(k) 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.
The Fed's recent hints at higher interest rates could provide a windfall for PAYX. Historically, the firm has earned considerable revenues from the interest float on the huge amount of cash it holds for payroll checks. Any interest earned between the time employers wire it to Paychex and employees cash their paychecks goes in the firm's coffers. That means there's a huge revenue stream waiting to be unlocked when rates perk back up.
Last but not least is industrial supplier Fastenal (FAST).
Fastenal actually has the "honor" of being the most-hated name on our list today. With a short interest ratio of 21.97, it would take more than a month of buying for shorts to exit their positions in this stock. Even though Fastenal's business isn't particularly exciting, the upside potential from a short squeeze in FAST certainly is.
Fastenal is an industrial supply company with more than 2,400 retail locations spread across the country. One of Fastenal's biggest benefits is its huge product catalog. The firm carries more than 410,000 types of fasteners and more than 585,000 maintenance and repair products, an inventory that makes Fastenal a one-stop shop for its customers. And because of its scale, the firm is better able to compete on cost and product availability than most of its smaller peers. It's also better equipped to offer innovative new solutions like industrial vending machines that are installed in customer shops, improving part availability and tracking resources.
There are still considerable growth opportunities for FAST right now, and that's reflected in the firm's P/E ratio of 32. There's no question that this isn't a cheap stock right now, but with fundamental growth and technical momentum starting to perk up in shares, the big price tag matters less than shorts believe this summer.
Look for a potential short squeeze catalyst in Fastenal's July 11 earnings release.
To see these short squeezes in action, check out this weeks Short Squeezes portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.