On Aug. 25, 2010, Green Mountain Coffee Roasters (Nasdaq: GMCR) was:

  • Sporting a P/E greater than 50.
  • Seeing its stock reach record highs, having gone up over 300% in the previous two years.
  • Was being heavily shorted.

Clearly, this was a stock to avoid, right? Wrong.

On that day, Chief Rule Breaker David Gardner recommended that his members buy Green Mountain. And how has that worked out?

The stock is up 190%.

Two things David Gardner knows that you should, too
When conventional wisdom was so sure Green Mountain was going down, how did David make out like a bandit? Well, he knew he had two huge variables in his favor:

  1. Innovation wins out.
  2. Heavily shorted stocks can jump on any sign of good news.

First, let's deal with innovation. When David Allen, author of Getting Things Done, visited Fool headquarters in 2006, David Gardner asked Allen what CEO impressed him the most. Allen's response: Green Mountain founder Robert Stiller. That praise, along with a realization that the company's Keurig coffeemakers were becoming ubiquitous, was a strong endorsement for our co-founding Fool.

What's a "short"?
Second, let's tackle this issue of shorting stocks. Here's a 30-second guide to how it works:

  1. Adam decides that Blockbuster's stock -- which is trading for $10 -- is going to fail.
  2. Adam goes to Eric, borrows Eric's 10 shares of Blockbuster, and sells them on the open market, pocketing $100.
  3. Adam waits for Blockbuster's shares to drop. Once they get down to $5, Adam "covers" his shares by repurchasing them on the open market.
  4. Adam gives the 10 shares back to Eric. Because he pocketed $100 from selling the shares, but only paid $50 to get them back, Adam has made $50.

Simple enough, right?

Well, there's a lot that can go wrong in the process. Let's say Adam was wrong about Blockbuster. Instead of dropping, the shares went up to $15. Adam has two choices:

  • Wait for the price to (hopefully?) go down.
  • Cover his shares and accept a loss of $50 -- and counting.

When a stock you're shorting starts creeping up in price, hanging on can quickly become a game of nerves.

Heavily shorted stocks
When the market looks down on certain stocks, short sellers often start to pile on. Intuitively, you might think it's a bad idea to buy stocks that are heavily shorted, and it's true -- shorts can be an important warning sign. But if you're right, and the shorts are wrong, stocks with heavy short positions can turbocharge your portfolio.

Consider our example of Green Mountain. In mid-March, the company announced that it had entered into a strategic partnership with its biggest competitor, Starbucks. This set off a vicious cycle for short sellers.

Some, believing that Green Mountain's stock would rise considerably, decided to cover their shares. When short sellers cover their shares, demand for a stock increases. When demand for a stock increases, the price of the stock goes up ... causing even more short sellers to panic and cover their shares. And so on.

I'm pretty sure you can see how this plays out. Wall Street calls this cycle a "short squeeze." And innovative companies with a history of surpassing market expectations can create the mother of all short squeezes.

The perfect storm
Below are six innovative companies currently attracting a lot of attention from short-sellers, as well as the percent of their available shares (float) being shorted.

Company

What They Do

Short % of Float

Entropic (Nasdaq: ENTR) Connects your home's electrical devices 33%
Soda Stream (Nasdaq: SODA) Soda-making machines for the home 30%
Ebix (Nasdaq: EBIX) On demand e-commerce solutions for the insurance industry 32%
Travelzoo (Nasdaq: TZOO) Travel and local deals 45%
First Solar (Nasdaq: FSLR) Solar power 39%
Coinstar (Nasdaq: CSTR) Redbox DVD rentals and coin-counting machines 37%

Source: Finviz.com.

With earnings season right around the corner, there will be opportunities for good news to create a short squeeze. And looking at the historical numbers, there's a good chance these six could report strong earnings and see their shares jump. Just look at the consecutive quarters in which these companies have beaten analysts' earnings estimates, and by how much.

Company

Consecutive Beats

Average Beat

Entropic 11 27%
Soda Stream 2* 119%
Ebix 8 18%
Travelzoo 7 167%**
First Solar 15 36%
Coinstar 5 46%

Source: E*TRADE.
*Soda Stream only has two quarters of earnings in its company history.
**Excluding a one-time charge to the state of Delaware in the last quarter.

Foolish takeaway
Of course, nothing is a sure bet. Short-sellers may well have the last laugh with some of these stocks. But long-term investors in unloved, innovative companies can benefit from a short squeeze.

If you're interested in other innovative companies that Wall Street is betting against right now, I'm willing to offer you a special free report, The Motley Fool's Top Stock for 2011. Inside, you'll find out about a little company set to profit from the broadband Internet explosion. It just so happens that this stock currently has 7% of its shares being sold short right now, too. Click here, and the report is yours for free!

Fool contributor Brian Stoffel used his two brothers as the short-seller examples. He owns shares of Travelzoo and Starbucks. The Motley Fool owns shares of Ebix. Motley Fool newsletter services have variously recommended buying shares of SodaStream International, Coinstar, First Solar, Ebix, and Green Mountain Coffee Roasters, creating a lurking gator position in Green Mountain Coffee Roasters, and recommended shorting Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.