They're certainly fun trades to make, assuming you time them just right. But no serious long-term investor sees spotting prospective short squeezes as a sound stock-picking strategy. There's just too much luck and strategy needed to consistently make money with the approach.
That's not to suggest, however, that a short squeeze candidate can't be a stock worth owning for the long haul. Plenty of great publicly traded companies -- particularly young ones -- see their shares occasionally targeted by short-sellers looking to make a quick, easy buck. Sometimes a good short squeeze rally is all that's needed to get these tickers moving higher once and for all, ultimately driven upward by that company's actual growth.
Upstart Holdings (UPST -0.58%) is one such name right now, ripe for a short squeeze that could be the beginning of so much more.
Image source: Getty Images.
What's a short squeeze?
If you're not familiar with the term, a short squeeze is simply a rally sparked by significant fear-induced buying of a stock from traders who have sold those shares short. A short sale simply means a trader has sold a stock they don't currently own with the aim of buying it back at a lower price on a later date.
Yes, it's completely legal.
There's something of a catch for short-sellers, though, that doesn't apply to the conventional "buy low, sell high" approach to investing. That is, while the maximum risk anyone assumes in owning a stock is limited to the amount put into that particular investment, the potential risk in selling a stock short is technically infinite. See, the only way to close out a short position is by buying the stock back. The only question is, at what price?
That's how short squeezes got their name, by the way -- the higher a stock climbs, the more panicked a short seller gets. Eventually, they may be all but forced to buy the stock back at a loss to cover their position, which ironically enough only further fuels that rally, putting even more pressure on other short sellers of that stock.
To this end, as of the most recent look, a whopping 22.5% of Upstart's 84.6 million outstanding shares are shorted, with many of those trades inspired by the stock's clear weakness since October. For comparison, the S&P 500's current short interest is a relatively typical sub-2%.
In short (pun completely intended), a bunch of people are going to have to buy shares of Upstart sooner or later. The thing is, that time could come sooner than later.
Unsurprisingly successful
But what's going to prompt the short of bullishness that sends all these short-sellers into a panic-prompted buying frenzy? Upstart Holdings' story.
It's simple enough. After years of limited competition, disinterest in improvement, and a little hubris, credit bureaus Equifax (EFX -8.49%), Experian (EXPG.Y -2.86%), and TransUnion (TRU -3.76%) are no longer the highly trusted means of assessing an individual's creditworthiness that they used to be. All three have their own methods of calculating a credit score in-house (VantageScore is what they call it), And Equifax and Experian rely heavily on a borrower's FICO score. Using an algorithm and artificial intelligence, Upstart Holdings has developed its own scoring system that management says factors in many more variables to more accurately calculate how likely it is someone will actually repay borrowed money.
The merits of the company's approach can be seen in the numbers. The company's own internal study suggests its creditworthiness measures result in 75% fewer defaults than banks' typical approval process that depends heavily on traditional credit bureaus. Or, looking at the data from a different perspective, Upstart's method allows for 173% more approvals than loans based on traditional credit scores without any additional loan losses.
Impressed? So are Firstmark Credit Union, Red Rocks Credit Union, Subaru, Volkswagen, Corning Credit Union, and AgFed Credit Union, all of which have tapped Upstart this year alone to help them make smarter lending decisions. These lenders join a bunch of others that signed up last year, which collectively generated a total of $849 million worth of revenue in 2021, up 264% from 2020's top line. The company's starting to beef up its operating profits in a big way as a result too, producing $135 million in net income last year versus only $6 million the year before. The analyst community is looking for comparable growth this year, and beyond.
Data source: Thomson Reuters. Chart by author. Revenue figures are in millions of dollars.
It's not a stretch to suggest the stock's short-sellers just didn't see this sort of success coming, or being sustained.
Patiently own Upstart Holdings for the right reasons
While Upstart Holdings stock may be ripe for a short squeeze, that doesn't necessarily mean one is in the works. It often takes a catalyst or even a deliberate effort from speculative investors to snap a stock out of a downtrend and into a short-squeeze rally. And there's never any assurance these will be effective ... at least not at the point in time you'd expect them to be.
For true buy-and-hold investors, though, the exact timing of such moves doesn't matter. This stock's prospects are compelling because the company's capitalizing on an opportunity with real staying power. As is usually the case, time will do most of whatever heavy lifting there is to be done here.
