In March 2021, Reddit investors made headlines by sending GameStop (GME -0.10%) rocketing through a short squeeze. To short a stock means to bet against it, so the investor profits as the stock price moves lower. The shorting mechanism works by borrowing a share from a shareholder at the opening price and then selling it. The borrowing party closes out their trade by purchasing a new share which is returned to the original owner. For example, if I borrow a share from you at $50 (opening a short position) and then the stock moves to $40, I made a $10 profit because I borrowed and sold the share at $50 and returned the share after it was purchased for $40.
If the share price moves higher instead, many short sellers may be forced to close out their bearish positions. Brokerages typically have automatic short-sale liquidation rules in place, triggered by unreasonably large losses on paper.
A short squeeze occurs when many short positions are closed at the same time. Because there would be massive purchasing volume (to buy back the shares) and normal to low selling volume, the price rises due to supply and demand laws -- sometimes causing another wave of automatically managed closings. And then the vicious cycle continues.
This action was exaggerated with GameStop, as 141% of shares were sold short at its peak, meaning there weren't enough shares available to cover the short positions.
Image source: Getty Images.
While the days of more than 100% short interest are probably over, three stocks with high short-squeeze potential due to large short positions are Lemonade (LMND 1.02%), Wayfair (W -0.91%), and GoodRx (GDRX -0.37%). All it takes is one positive news catalyst for the short positions to be closed out at the same time for a pop to occur.
Lemonade
Sitting at 35% short interest, Lemonade is the most heavily shorted stock of the three. It is disrupting legacy insurance providers by using artificial intelligence (AI) to provide quotes in around 90 seconds and pay claims in three minutes. After starting in renters insurance, it has expanded to include policies for homeowners, pets, term life, and auto insurance.
The shorts are betting against Lemonade because of its high valuation and unprofitability. Even though it is a tech-focused insurer, it is still an insurance company with razor-thin margins. The table compares Lemonade to a software-as-a-service tech company with a similar bottom-line profit margin.
| Company | Gross Margin | Profit Margin | Price-to-Sales Ratio |
|---|---|---|---|
| Lemonade | 33% | (19%) | 21 |
| Procore | 82% | (16%) | 17 |
Data source: Lemonade and Procore.
With a low gross margin, there is less room for operating expenses and profits. Because of this, lower gross margin companies often have a reduced valuation multiple. As the table illustrates, the market still values Lemonade highly versus a tech company.
An item that could trigger a short squeeze is a wide expansion of Lemonade's car insurance offering, as it is only available in Illinois so far. This would accelerate Lemonade's customer growth; last quarter the customer count rose 45% to more than 1.3 million, compared to the year-ago period's figures. Still, insurance is a slow-moving business and switching can be a hassle. Investors should play the long term with Lemonade, rather than hope for a blink-and-you-miss-it short squeeze.
Wayfair
The pandemic gave Wayfair a huge boost. Many consumers were not willing to enter a furniture store where others may have touched common surfaces. Instead, they turned to online retailers to spend their extra money boosted by stimulus checks. Now that the surge has subsided, Wayfair is struggling.
During the third quarter, its revenue decreased 19% since last year, and it was unprofitable this quarter while it turned a profit last year. 22% of shares are sold short, setting the stage for a potential short squeeze.
As it sells home goods, most consumers don't make repeat purchases. The pandemic boost condensed much of this spending into a single time frame, skewing the results. One bright note for Wayfair: Active customers increased by 1.5% over last year, showing shopping for home goods online isn't a pandemic fad.
Wayfair can generate a short squeeze this year by reporting strong revenue growth -- something that could happen as its results will not be compared to inflated pandemic numbers. In additon, a surprise profit could send the stock skyrocketing.
GoodRx
GoodRx provides its users with the best possible prescription cost available. The company estimates it helped fulfill at least 80 million prescriptions that would have otherwise gone unfilled due to cost alone. Customers love GoodRx, which is showcased by its unbelievable net promoter score -- a measure of how much users advocate for the brand -- of 90, a world-class score.
Q3 revenue growth was solid at 25%, but its subscription offering segment stole the show by increasing 111% year over year. While it only makes up around 10% of total revenue, continued growth will make this a much larger chunk of the business.
Short interest sits at 21%, but this may be driven by the recent high growth/unprofitable stock sell-off.
GDRX PS Ratio data by YCharts
With its lowest valuation as a public company, buyers might start scooping up this stock at depressed prices, and potentially trigger a short squeeze.
GoodRx almost turned a profit in Q3, as its net margin was only -9%. It has plenty of room to work with its astounding 94% gross margin. If it cuts back on its hefty sales and marketing spend -- 49% of revenue -- GoodRx could turn a profit and cause the shorts to head for the exit.
With all three businesses, short squeezes are possible. However, this only provides a single short-term pop. Investors need to examine the business for a better investment thesis than just the possibility of a short squeeze. If the squeeze never comes, then the company will need to execute on its business side to provide solid returns. And if it does materialize, it may take an inhumanly accurate trigger finger on the "sell" button to capture any of the sudden value boost. While I'm unsure of how Wayfair will prosper in the post-pandemic world, both GoodRx and Lemonade have great industry trends on their side.
