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Shorting stocks is a gutsy call. When you borrow shares just to sell them, you're betting cold, hard cash that share prices will fall. It's a play with unlimited downside, but a maximal gain of 100% -- exactly the opposite of simply buying the stock. So, when a large number of shares fall in the short-selling camp, the investors behind the positions must have done their homework and found the stock severely lacking. Why else would you stick out your neck with such a counter-intuitive and risky investment?
But investors are not robots with perfect information and zero emotion behind every move. Sometimes, big short positions simply set shares up for a massive jump as the bearish thesis unravels. Some of these stocks represent broken companies or ridiculous valuations that deserve a hard fall. Others are just misunderstood.
Where does Netflix (Nasdaq: NFLX ) and its 23.6% short ratio fall on that scale? To find out, let's look at why some market movers hate the stock. Yesterday, Cnet writer Greg Sandoval appeared on CNBC to highlight Amazon as the most likely Netflix killer, for example. But all of that is just noise. The real price-busting damage happened long ago,
Echoes of 2011 are still ringing in many a head. Netflix was worth more than $300 per share in the spring, as the streaming video story started to get traction. Then the stock fell apart, losing more than 80% of its peak value, at worst. CEO Reed Hastings came up with one necessary pricing change, and one face-palmingly bad idea called Qwikster, and the company handled both announcements with all the finesse of a Bulgarian weightlifter performing brain surgery.
Shares dusted themselves off and got back to their feet in January, when strong holiday numbers showed that the red tide of fleeing subscribers was slowing down. But that didn't last either: Netflix fell again in April, because the guidance for new subscribers over the summer fell short of market expectations.
And therein lies the rub. If you've paid attention to the Netflix story, and particularly to the dynamics of its streaming video business, you've read management's detailed explanation of seasonality effects, shrugged, and moved on. But many investors, analysts, and media pundits don't understand how the seasonal ebb and flow of subscribers really works. For an in-depth explanation, see the company's latest letter to shareholders. In plain English, the summer is soft, and most subscriber additions happen in the second half of the year.
Tasting the squeeze
These shares have been clobbered hard in the last three months, perking up only as Hastings let slip some encouraging streaming traffic information via a Facebook (Nasdaq: FB ) post. The social-media nature of that disclosure is not sitting well with some critics, but the actual information led to a 25% price gain -- and counting.
That brings us back to the short-sellers. Some of the recent gains likely came from shorting positions closing out. Rising prices tend to reinforce themselves on heavily shorted stocks, thanks to the short squeeze effect. Remember the massive downside risk we talked about earlier? A squeeze is what happens when a large number of investors, big and small, decide that enough is enough -- time to close the risky short position before you take too much financial damage.
And this is just the start of the squeeze. When Netflix reports earnings in two weeks, I expect Hastings to present strong subscribers guidance for the fall quarter, according to the already-known seasonal pattern -- and that will still come as a surprise to many a Netflix bear. It shouldn't, but it will. So a big pop is inevitable, amplified by fleeing short-sellers.
Netflix is a tremendous long-term play. The skeptics magnify its short-term ebbs and flows, so opportunistic investors can make huge gains by playing the cycles of the story. Personally, I've got a bullish call spread going on Netflix to take advantage of the current misunderstandings. It breaks even at about $100 per share, and I'll close it out at $115, where the gains are capped by my written call. This will most assuredly happen before next January, and might even play out in July if the short squeeze is strong enough.
In short, plenty of smart money is very wrong about Netflix today, and will take some damage in 2012. But the smartest investors buy when everyone else is selling, because that's how you make the biggest returns. Netflix is something those geniuses might be picking up right now, but some of their other choices will really shock you. To check out the investment story on one of the “Netflix Killers,” Apple, just click here to access the Fool’s new premium research report on the iEverything maker.