For most investors, 2022 was an abysmal year. The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite, all plunged into a bear market and produced their worst returns since 2008.

On the other hand, it was the perfect scenario for short-sellers to profit. Short-sellers are investors who make money when the price of a security declines. Though short-selling can be quite profitable, it's worth pointing out that gains are capped at 100% (a stock can't fall below $0), while losses are, in theory, unlimited.

Normally, short-sellers tend to target companies with obvious flaws or red flags. This could include operating issues, management miscues, a debt-laden balance sheet, adverse legal judgments, or perhaps even valuation concerns. In many instances, stocks with a large amount of short interest have serious questions in one or more of these aforementioned categories and are deserving of skepticism. But that's not always the case.

A rocket made out of rolled cash bills being launched into outer space from Earth.

Image source: Getty Images.

As of last week, 85 publicly traded companies with market caps above $300 million had at least 20% of their float -- the tradable number of shares -- sold short. Three of these heavily short-sold stocks stand out as being fully capable of burning short-sellers big-time in 2023.

Upstart Holdings: 38.3% of float sold short

The first heavily short-sold stock that could lead to a short squeeze on pessimists is cloud-based lending platform Upstart Holdings (UPST -1.95%).

The skepticism surrounding Upstart's operating model is easy to understand. With the Federal Reserve tackling historically high inflation, it's had to raise interest rates at the fastest clip in four decades. As rates rise, the attractiveness of borrowing money fades quickly for both consumers and businesses. That's not exactly great news for a company operating a lending platform, and we're certainly seeing this weakness in its top-and-bottom-line results.

However, it can also be argued that the pessimism directed at Upstart is already baked into its valuation given the well-defined competitive advantages it offers.

Whereas the lending industry has been relying on the same slow and costly loan-vetting process for decades, Upstart's platform utilizes artificial intelligence (AI) and machine-learning to expedite and improve loan vetting. During the third quarter of 2022, a record 75% of loans directed through its platform were approved and entirely automated. That saves time and money for the company's close to seven dozen bank and credit union partners. 

What's been truly remarkable about Upstart has been its ability to expand the universe of borrowers without worsening credit risk. More specifically, even though loans processed by Upstart have lower average credit scores than traditionally vetted loans, the delinquency rate between the two has been similar. The implication here -- and the reason nearly seven dozen lending institutions partnered up with Upstart -- is that Upstart can bring banks and credit unions new customers without worsening their credit profiles.

Additionally, Upstart is just getting its feet wet in auto loans and small business loans, which are considerably larger loan origination markets than personal loans.  The latter has been Upstart's focus for the past couple of years. If the nation's central bank lets its foot off the gas and pauses rate hikes in the first-half or first quarter of 2023, Upstart could see a noticeable rebound in loan processing demand that catches pessimists off-guard and potentially incites a short squeeze.

Petco Health and Wellness: 20.7% of float sold short

A second remarkable stock that has all the tools and intangibles needed to burn short-sellers in the new year is pet-focused retailer Petco Health and Wellness (WOOF -1.91%).

As of Dec. 30, 2022, more than 30 million shares of Petco were held by short-sellers, which was up considerably from the end of November. This skepticism appears to be the result of higher-than-anticipated integration expenses from Petco's acquisition of veterinary-care business Thrive. It could also be argued that short-sellers anticipate softness across the board for retailers in 2023 given the numerous warning signs that a U.S. recession is likely.

On the other hand, short-sellers could be barking up the wrong tree with Petco Health and Wellness.

A strong case can be made that the pet industry is one of the most recession-resistant industries on the planet. It's been well over a quarter of a century since U.S. pet expenditures declined on a year-over-year basis, according to data from the American Pet Products Association (APPA). Further, the latest APPA survey notes that 70% of U.S. households owns a pet, which is the highest figure since APPA began its survey in 1988.  More pets mean more opportunity for a pet-focused retailer like Petco.

But it's Petco's investments and business transformation that could really surprise short-sellers in 2023. As an example, the company really bulked up its online presence in the wake of the pandemic. Digital sales jumped 10% during Petco's fiscal third quarter (ended Oct. 29, 2022) and 42% when compared to Q3 2020.  Convenience is key with shoppers, and Petco's management team got the message.

Petco is also heavily pushing its subscription services, which includes access to pet grooming, on-site veterinary care, and discounts on various products throughout its stores. When coupled with offering pet insurance, Petco has made a number of moves designed to bolster its operating margin, foster repeat visits, and improve customer loyalty.

With Petco Health and Wellness unlikely to be adversely impacted by a U.S. recession, it could be primed to put a hurting on short-sellers.

A physician administering a vaccine into the upper-left arm of a patient.

Image source: Getty Images.

Novavax: 38.9% of float sold short

The third and final remarkable stock capable of burning short-sellers big-time in 2023 is biotech stock Novavax (NVAX 2.77%). In terms of short float percentage, Novavax is the highest among the three stocks being discussed (nearly 39%).

The bear case for Novavax primarily revolves around the company's COVID-19 vaccine miscues. Novavax delayed its emergency-use authorization filing in a number of developed markets on multiple occasions, as well as endured production ramp-up issues that allowed competing vaccine producers to gobble up the proverbial low-hanging fruit (i.e., initial series vaccines). Whereas Moderna racked up as much as $19 billion in advanced purchase agreements in 2022, Novavax is only expected to have reached $2 billion in sales.

However, Novavax wouldn't be on this list if it didn't have catalysts capable of putting short-sellers in their place.

The first thing to note about Novavax is that its COVID-19 vaccine is differentiated. Whereas the two most-popular COVID-19 vaccines are messenger-RNA-based, NVX-CoV2373 from Novavax is protein-based and uses older technology to teach a person's immune system how to recognize and fight infection. This differentiation, coupled with high initial vaccine efficacy (90.4%) in a 2021 U.S./Mexico trial, should help Novavax become more competitive as COVID-19 vaccines transition from advanced purchase agreements to the private market this year.

What's arguably even more interesting from an investment standpoint is the future potential of the company's vaccine-development platform. Aside from developing strain-specific COVID-19 vaccines, Novavax's pipeline offers promise with vaccines for influenza, respiratory syncytial virus, and combo therapies (influenza + COVID-19).

Lastly, Novavax is well-capitalized. Although Wall Street was less than thrilled with the company's convertible note and share offering in December that raised approximately $250 million in gross proceeds, it was sitting on a hearty $1.28 billion in cash and cash equivalents at the end of September, prior to this raise.  Novavax has more than enough capital to see its clinical trials through and continue innovating.