10 Heavily Shorted Stocks

There are stocks that the market is betting against, and then there are stocks the market is betting against. This summer, we surveyed the most common shorts on the market based on shorted shares outstanding (shorting is essentially betting against a stock and making money if it goes down). Our list was dominated by market indexes and giant companies -- like Cisco Systems (NASDAQ:CSCO) -- because money managers are hedging positions or betting (and losing) against the rising market.

That's to be expected.

Today, we're looking at an entirely different list: The 10 most heavily shorted stocks on Nasdaq when measured on a ratio of shares shorted to the stock's average daily volume. Imagine a company trades an average of 500,000 shares a day. If 5,000,000 of its shares are sold short, a whole 10 days of average volume would be required for all the bears to cover ("buy back") their short positions. On the one hand, that's significant future buying pressure for the stock, but on the other hand, high short interest unfurls a big caution flag.

That's why short interest data are worth considering each month as they're updated. The market's most heavily shorted stocks provide investment ideas for two reasons:

1) Shorts may have beaten down a stock so much that it's due to rebound, and buying pressure from short covering will help lift it, as was likely the case recently with Netflix (NASDAQ:NFLX).

2) High short interest may indicate a failing company that other experienced investors could want to sell short as well, and that everyone should avoid buying.

Cutting to the chase, as of September 15, 2003, here are the 10 most heavily shorted stocks when measured against their average daily volume. Today, we're considering those on Nasdaq with average daily volume topping 500,000 (we'll study lighter traded stocks another day).

Now, a closer look at numbers in the first five:

You can see how a stock that trades only 697,000 shares per day could be given quite a boost by the buying pressure of 11.5 million short shares that will eventually need to be repurchased. (When a stock is sold short, it is "borrowed" from a broker and sold immediately, with the short-seller pocketing the proceeds. Eventually, the seller must buy back the shares and return them to the broker's inventory.)

Buying pressure only occurs if there's a reason to buy, however. So will short-sellers have cause to buy back the stocks listed above? In other words, will these stocks climb, a "short squeeze" lifting them higher? If not -- if the stocks only drift -- then shorts can sit safe, no matter how many have piled on.

We'll concentrate on the top two companies today, trying to figure out why they're so brutally shorted and if there's reason to expect this will backfire. Next week, we'll consider others in the list.

American Capital Strategies (ACAS)
The most heavily shorted stock on the list was ranked 15th on the list three months ago, so the bearishness has grown. The company is a buyout and debt-funding provider, focused on senior debt, subordinated debt, equity and other forms of capital to companies in need of cash for funding, acquisitions, liquidity and so forth. It typically loans from $5 million to $50 million with debt maturity in five to 10 years. So, it's a fancy lender to companies in need.

Revenue has leapt from $67 million in 2000 to $147 million in 2002 (with $20 million in resulting net income), the balance sheet looks healthy, and the company has decent free cash flow. American Capital trades at a forward P/E of 9, and at $25, the stock yields an 11% dividend. Yes, 11%. This year, the stock is up 10%, and the last three months -- as shorting volume jumped -- the stock is about flat.

Everyone shorting the stock needs to pay the 11% dividend out of pocket, so they must have great reasons to continue shorting. Perhaps they're betting that an upturn in the economy will slam the firm's business, because fewer companies will need the lending it provides. But I'm speculating. If you have insight as to why this company is so heavily shorted, drop me a note [writer's later addition: received enough notes, update next week], because I don't see a good reason to short from the numbers. Actually, I see the opposite.

Identix (IDNX)
Given the world's intense focus on security, you would think a firm that provides fingerprinting and face recognition technology would be bulletproof. Identix provides these and other security services to government and private business, including law enforcement, aviation, healthcare and financial operations -- basically, wherever there's a desire to keep nonsecured people out. The company won a $27 million government contract last week.

So, why is Identix the second-most heavily shorted stock on our list, with 8 million shares sold short (10% of available shares), when only 500,000 shares trade daily? Let's see.

The company has suffered steady losses and revenue rose only modestly from $81 million the year ended June 2001 to $92 million the year ended this June. That's less of an increase than one might expect. The balance sheet is strong with $40 million cash and investments and no long-term debt, although free cash flow is apparently foreign to the company.

Without earnings or positive cash flow, it's not easy to value the $6 stock, but the company's $500 million market cap does seem generous given $92 million in profitless sales. The past six months, the stock is up about 40%. Five months ago, Identix was number one on the short list. Now it's in second place, so most shorts are holding out, rooting for a lower price, even as they get hurt.

Conclusion
I prefer to short -- if at all -- companies struggling under enormous debt, declining sales and growing losses. Neither of these fit that bill, so I'm curious why they're so heavily shorted. Would a stronger economy really slam American Capital Strategies, or would it lead to more buyouts, acquisitions and expansions, all needing financing? Is Identix set to fall from $6 and revisit recent lows of around $4? In a stronger market and while it's winning new contracts, why would it?

Unless I hear compelling evidence suggesting otherwise, I wouldn't place my bets with the copious shorts. Instead, these stocks may be interesting possibilities to outperform in a rising market, and if each just steadily improves its business -- even little improvements, gradually -- it could be enough to start an upward avalanche.

Jeff Fischer does not hold a stake in companies looked at and was a write-in candidate for Governor of Nebraska. The Fool has a disclosure policy.