These Stocks Could Double Over the Next 2 Months

On Aug. 25, 2010, Green Mountain Coffee Roasters (Nasdaq: GMCR  ) was:

  • Sporting a P/E greater than 50.
  • Seeing its stock reach record highs, having gone up over 300% in the previous two years.
  • Was being heavily shorted.

Clearly, this was a stock to avoid, right? Wrong.

On that day, Chief Rule Breaker David Gardner recommended that his members buy Green Mountain. And how has that worked out?

The stock is up 190%.

Two things David Gardner knows that you should, too
When conventional wisdom was so sure Green Mountain was going down, how did David make out like a bandit? Well, he knew he had two huge variables in his favor:

  1. Innovation wins out.
  2. Heavily shorted stocks can jump on any sign of good news.

First, let's deal with innovation. When David Allen, author of Getting Things Done, visited Fool headquarters in 2006, David Gardner asked Allen what CEO impressed him the most. Allen's response: Green Mountain founder Robert Stiller. That praise, along with a realization that the company's Keurig coffeemakers were becoming ubiquitous, was a strong endorsement for our co-founding Fool.

What's a "short"?
Second, let's tackle this issue of shorting stocks. Here's a 30-second guide to how it works:

  1. Adam decides that Blockbuster's stock -- which is trading for $10 -- is going to fail.
  2. Adam goes to Eric, borrows Eric's 10 shares of Blockbuster, and sells them on the open market, pocketing $100.
  3. Adam waits for Blockbuster's shares to drop. Once they get down to $5, Adam "covers" his shares by repurchasing them on the open market.
  4. Adam gives the 10 shares back to Eric. Because he pocketed $100 from selling the shares, but only paid $50 to get them back, Adam has made $50.

Simple enough, right?

Well, there's a lot that can go wrong in the process. Let's say Adam was wrong about Blockbuster. Instead of dropping, the shares went up to $15. Adam has two choices:

  • Wait for the price to (hopefully?) go down.
  • Cover his shares and accept a loss of $50 -- and counting.

When a stock you're shorting starts creeping up in price, hanging on can quickly become a game of nerves.

Heavily shorted stocks
When the market looks down on certain stocks, short sellers often start to pile on. Intuitively, you might think it's a bad idea to buy stocks that are heavily shorted, and it's true -- shorts can be an important warning sign. But if you're right, and the shorts are wrong, stocks with heavy short positions can turbocharge your portfolio.

Consider our example of Green Mountain. In mid-March, the company announced that it had entered into a strategic partnership with its biggest competitor, Starbucks. This set off a vicious cycle for short sellers.

Some, believing that Green Mountain's stock would rise considerably, decided to cover their shares. When short sellers cover their shares, demand for a stock increases. When demand for a stock increases, the price of the stock goes up ... causing even more short sellers to panic and cover their shares. And so on.

I'm pretty sure you can see how this plays out. Wall Street calls this cycle a "short squeeze." And innovative companies with a history of surpassing market expectations can create the mother of all short squeezes.

The perfect storm
Below are six innovative companies currently attracting a lot of attention from short-sellers, as well as the percent of their available shares (float) being shorted.

Company

What They Do

Short % of Float

Entropic (Nasdaq: ENTR  ) Connects your home's electrical devices 33%
Soda Stream (Nasdaq: SODA  ) Soda-making machines for the home 30%
Ebix (Nasdaq: EBIX  ) On demand e-commerce solutions for the insurance industry 32%
Travelzoo (Nasdaq: TZOO  ) Travel and local deals 45%
First Solar (Nasdaq: FSLR  ) Solar power 39%
Coinstar (Nasdaq: CSTR  ) Redbox DVD rentals and coin-counting machines 37%

Source: Finviz.com.

With earnings season right around the corner, there will be opportunities for good news to create a short squeeze. And looking at the historical numbers, there's a good chance these six could report strong earnings and see their shares jump. Just look at the consecutive quarters in which these companies have beaten analysts' earnings estimates, and by how much.

Company

Consecutive Beats

Average Beat

Entropic 11 27%
Soda Stream 2* 119%
Ebix 8 18%
Travelzoo 7 167%**
First Solar 15 36%
Coinstar 5 46%

Source: E*TRADE.
*Soda Stream only has two quarters of earnings in its company history.
**Excluding a one-time charge to the state of Delaware in the last quarter.

Foolish takeaway
Of course, nothing is a sure bet. Short-sellers may well have the last laugh with some of these stocks. But long-term investors in unloved, innovative companies can benefit from a short squeeze.

If you're interested in other innovative companies that Wall Street is betting against right now, I'm willing to offer you a special free report, The Motley Fool's Top Stock for 2011. Inside, you'll find out about a little company set to profit from the broadband Internet explosion. It just so happens that this stock currently has 7% of its shares being sold short right now, too. Click here, and the report is yours for free!

Fool contributor Brian Stoffel used his two brothers as the short-seller examples. He owns shares of Travelzoo and Starbucks. The Motley Fool owns shares of Ebix. Motley Fool newsletter services have variously recommended buying shares of SodaStream International, Coinstar, First Solar, Ebix, and Green Mountain Coffee Roasters, creating a lurking gator position in Green Mountain Coffee Roasters, and recommended shorting Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (116)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 03, 2011, at 3:01 AM, TrackSterman wrote:

    Every study ever done has shown that high short interest is correlated with abnormally negative returns. Reckless advice...

  • Report this Comment On July 04, 2011, at 4:59 PM, rrabideau wrote:

    I havnt read the studies you speak about but sure they could be LONG term correlated but short term not necessarily.

    Short selling in itself can cause the price to drop as they sell but typically it can catapult the stock with good news.

  • Report this Comment On July 04, 2011, at 5:24 PM, TMFCheesehead wrote:

    I would be curious to see this study as well. From a purely technical standpoint, it's the act of the shares being sold (short) that drives the price down and the act of them being bought back (covered) that drives it back up. Although these stocks could be shorted even more, their levels are already very high as is.

    Looking past all that, I didn't just pick any old stocks being shorted, but ones that I thought had an innovation edge.

    Brian Stoffel

  • Report this Comment On July 04, 2011, at 7:07 PM, jm7700229 wrote:

    What happened to buy and hold? Since when do you push market timing? If I want to gamble, I will go to Las Vegas. Buying an obviously overpriced stock just because it MIGHT be in a short squeeze is contrary to all of your normal advice, and is a pure gamble, not an investment.

    I'm REALLY disappointed in you guys.

  • Report this Comment On July 04, 2011, at 8:29 PM, AlphaVolume wrote:

    trying to be the greater fool can be a dangerous game...good luck. im short GMCR

  • Report this Comment On July 05, 2011, at 12:03 AM, TMFCheesehead wrote:

    Jm-

    I appreciate where you're coming from. I think our advice is varied, and can't be summarized as a whole in one sentence. If forced to, however, I would say we advocate buying companies, not just stocks.

    If we really believe in the innovativeness of these companies, they deserve our attention. If others are betting against these companies b/c of stock technicals, that can offer us even greater incentive to buy as we believe the stock is underpriced relative to it's potential, not overpriced.

  • Report this Comment On July 05, 2011, at 11:01 AM, gbills wrote:

    hey maybe a shot at another newsletter "buy these shorted stock portfolio"

  • Report this Comment On July 05, 2011, at 12:06 PM, PhredFirecloud wrote:

    A study of the relative performance of heavily shorted vs lightly shorted stocks over 20 day periods.

    http://www2.lcb.uoregon.edu/App_Themes/Content/Docs/sac/Boeh...

  • Report this Comment On July 05, 2011, at 1:02 PM, TMFCheesehead wrote:

    @Phred-

    Just read the abstract, thanks so much for the link. Will definitely read this when I get the time.

    Brian Stoffel

  • Report this Comment On July 05, 2011, at 1:09 PM, IsaCann wrote:

    It's one thing to be a dirty company glossing over corporate irresponsibility to the environment, but Green Mountain takes the unacceptable step of promoting themselves as the real Green deal. The whole Keurig line is a gross waste of natural resources and encourages the ignorant consumer to further develop the unsustainable Disposable Culture that the US sadly embraces.

  • Report this Comment On July 05, 2011, at 3:43 PM, Gregeph wrote:

    No one can consistently predict short term price movements of stocks. This approach is speculating, not investing.

    Learn to value companies and buy them when their price is materially lower than their value. Then hold tight. This approach works and has generated great wealth. My blog focuses on this approach. If interested, http://gregspeicher.com/.

  • Report this Comment On July 08, 2011, at 10:08 PM, dansocko wrote:

    There are several approaches to take when evaluating a company and its stock to determine if it is underpriced. Increasingly short positions play a role, so you can almost argue that you do not need to know that shorting is causing the low value. If you do fundamentals and determine that it is a buy, when others agree with you and a short squeeze results, that is an extra bonus, but perhaps not the only reason to buy.

  • Report this Comment On July 14, 2011, at 1:18 AM, awallejr wrote:

    My concern with SODA for example is it is probably a fad. They tried the same thing like 40 years ago to challenge coke or pepsi. But in the end people are lazy. They want to open the fridge and grab a can.

  • Report this Comment On July 16, 2011, at 7:38 PM, David369 wrote:

    I remember several years ago when people were saying "who the heck would want DVDs by mail when there is a Blockbuster just down the street?" Netflix's PE was "way too high", who would be dumb enough to invest?

    Then there was that Apple company...and Google was only a search engine how are they going to make any real money? Bet you one or more of the companies mentioned does quite well. I just don't want to gamble on it and maybe that's why I'm not rich (or maybe why I'm not broke yet). If there was a reliable, definitive indicator of a stock's future success then there would not be a need for Motley Fool.

  • Report this Comment On July 20, 2011, at 5:30 AM, Jakarta42 wrote:

    I expected gold to go up and bought CNL, (Torronto Stock exchange) a gold mining company. The stock did very well although not much financial data was available. ($1.60-$10.18)

    Now = at approx. $7.50

    It has good assay reports and reserves.

    The original investors had another IPO.

    Symbol SVV same exchange.

    Gold keeps climbing.

    Good luck

  • Report this Comment On July 21, 2011, at 4:39 PM, 123audrey wrote:

    wprt? what's happening? did law pass yet

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