Are There Buying Opportunities Among Popular Shorts?

Generally, I view stocks with strong short interest cautiously. With unlimited downside risk, short sellers do their homework, and have a history of identifying shortcomings (pun intended) in stocks before other investors. David Einhorn's calls on Allied Capital (NYSE: ALD  ) and Lehman Brothers, and Whitney Tilson's call on Palm (Nasdaq: PALM  ) are examples.

At the same time, pessimism about a company's future may be a buying opportunity. Significant share float sold short is a pessimistic signal for a stock. If the pessimism is unfounded, a diamond in the rough may make a good investment, and it may enjoy a price pop when short sellers cover.

To find stocks that might have this potential, I screened for the following:

  • Significant short positions -- at least 15% of float
  • Liquidity -- quick ratio above 1.5
  • Fundamentals -- annualized sales growth of at least 10% over last five years
  • Valuation -- forward P/E below 25 and price-to-free cash flow below 20

This yielded 20 stocks, including:

Company

Market Cap

Forward P/E

% Float Short

CAPS Rating (out of 5) 

Gymboree (Nasdaq: GYMB  )

$1.5 billion

11.9

19.1%

**

NutriSystem (Nasdaq: NTRI  )

$551 million

13.8

43%

***

Quidel (Nasdaq: QDEL  )

$420 million

20.8

20.2%

****

Under Armour (NYSE: UA  )

$1.5 billion

24.3

19.5%

****

Source: Finviz.com, Motley Fool CAPS.

A children's apparel retailer, Gymboree is trading near its 52-week high. The company has no debt, and it has grown earnings despite a weak economy. With 953 retail stores and plans to open more, short sellers may be concerned about the company's ability to expand profitably.

NutriSystem disappointed investors with forecasts of a weak first quarter. Partnerships with retailers such as Walmart's (NYSE: WMT  ) Sam's Club did not perform as anticipated last year, and sales continue to struggle. But, with a stock price 47% lower than its December 2009 52-week high, a stable dividend yielding nearly 4%, and promising results from its product designed for diabetics, bright spots remain.

A maker of diagnostic tests, Quidel, benefited from the H1N1 flu in 2009. Neither the company nor analysts expect a repeat in 2010, but with several infectious disease tests and reproductive health tests, the company's well-being isn't dependent on a pandemic. While still not cheap, the stock is down 23% from a 52-week high set in September.

Under Armour plans to retool its running and training footwear. The uncertain payoff to this investment and valuation may have investors concerned. However, with revenue that has quadrupled over the last five years and a successful track record of category expansion, it's hard to bet against the company.

These stocks are not specific recommendations, and there are reasons to be pessimistic, but I would argue the level of short selling seems overdone. Given the fundamentals and valuation, there just might be a buying opportunity.

More Foolish views on fearful stocks and short selling:

Fool contributor April Taylor does not own shares in any of the companies mentioned. Wal-Mart is a Motley Fool Inside Value pick. Under Armour is a Motley Fool Rule Breakers and a Motley Fool Hidden Gems pick. The Fool owns shares of Under Armour and has a disclosure policy.


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  • Report this Comment On April 05, 2010, at 3:22 PM, madmilker wrote:

    someone said Li was shorting the &*^@ out of Wal*Mart cause of this...

    on Wal*Mart's China web page!

    "Wal-Mart China persists in local procurement which provides more job opportunities, supports local manufacture industry and promotes local economy. So far, 95% of merchandising sold at Wal-Mart China store are local products by which Wal-Mart has established business relations with nearly 20,000 suppliers. At Wal-Mart, we treat suppliers as partners and would like to develop with them. In 2008 Wal-Mart won the Supplier Satisfaction published by Business Information of Shanghai for five consecutive years."

    something about not supporting American export and American jobs....

    but I don't think Li will make a difference until Chin, Wang, Cha and Chu short theirs....

  • Report this Comment On April 05, 2010, at 5:44 PM, akutach wrote:

    Any short sellers out there that care to comment???

    I currently do not, but I have some long positions in companies with substantial short interest (one with >35 days to cover that has been maintained that level of short interest over the last year - either they or I stubbornly have it wrong). My thesis for these companies is not a short squeeze play on a, but I do see significant short interest ratio as a bullish indication if everything else looks good to me.

    What drives somebody to take a short position? Does an existing high short interest make you want to short it too, or the opposite? We hear reference to wise critical investors who short judiciously to great profit, but are the bulk of short positions in the nature of follow-the-herd, hedging maneuvers, or just wishful thinking?

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