When short-sellers become skeptical of a given company's future prospects, they borrow its shares to sell them short, betting that the company's stock is likely to decline. Almost every stock currently trading is being shorted by someone somewhere, but some stocks are shorted much more often and much more heavily than others. Fortunately, investors have a way to keep tabs by monitoring short interest.
Short interest can be a powerful indicator, and a key tool for investors. It represents the proportion of a given company's shares that have been borrowed by short-sellers. For most companies, especially traditional blue chips, short interest is usually in the low single-digits. When it begins to rise above 10%, investors should take note. A high short interest indicates a controversial company, one whose shares could be poised to head much lower.
The smartwatch cometh
21.54% of Fitbit's outstanding shares were sold short as of March 15. That's a fairly sizable figure for a company that's turning a profit and trading with a reasonable valuation. Fitbit's trailing price-to-earnings ratio is just above 19, largely in line with the broader market. The problem is that Fitbit derives virtually all of its revenue from the sale of its wearable fitness trackers, a market that could dry up, or even vanish outright, in the years ahead.
Fitbit sells more wearables than any other firm -- it sold 8.1 million in the fourth quarter last year -- but its devices are simplistic. They can't run third-party apps, or integrate with existing smartphone platforms. The steady growth of smartwatches (which offer all of these features and more) poses a challenge -- perhaps an existential one. A consumer who buys an Android Wear watch, for example, is unlikely to pick up the new Fitbit Blaze, and that could strain the company's earnings in the years to come. Meanwhile, low-cost competitors such as Xiaomi are churning out similar trackers with ever-lower price tags.
Losing money with no credible plans for future profitability
Payment processor Square and Wi-Fi provider Gogo are in a different situation. Neither company is profitable, and it's not obviously clear that either will become profitable in the immediate future. For that reason, neither business can be valued under traditional metrics, and short-sellers may be skeptical of the value the market is currently placing on them. As of March 15, 29.68% of Square's shares and 28.81% of Gogo's shares had been sold short. Beyond valuation, there's doubts about the long-term viability of their businesses.
Square's potential for true long-term profitability may lie in the sale of ancillary services, rather than its actual core payment processing. Square has put an increasing degree of emphasis on its small-business products, including Square Capital and Caviar, through which it sells services to the merchants that use its readers. But the percentage of revenue that it derives from these services remains small -- less than 20% of its adjusted revenue last quarter. At the same time, its CEO, Jack Dorsey, splits his time between two firms (Square and Twitter).
Gogo is in a very different business, but is in a similar operating situation. The company has been unable to turn a profit providing its core product. The demand for Wi-Fi services should only increase as the number of connected devices multiplies, but it's not clear that Gogo will benefit. In February, American Airlines -- its partner --sued the company in an effort to get out of its contract, alleging that one of its competitors offered a better product.
Competition is intensifying
GrubHub also faces a high degree of competition. In addition to Square, Uber, Yelp, and Groupon have all entered the market for takeout delivery in recent quarters, while a number of high-profile start-ups also compete in the space. GrubHub is profitable, but its valuation may be stretched, as it trades with a trailing price-to-earnings ratio of more than 50. As of March 15, 29.15% of GrubHub's outstanding shares had been sold short.
A number of analysts have downgraded GrubHub in recent months, mostly due to competitive fears, but saturation in several key markets could also limit GrubHub's upside. Also, GrubHub has long been seen as a potential takeover target, which may have inflated its valuation in the past -- but as more competitors appear, its prospects for a favorable sale appear increasingly unlikely.
Burning investors, squeezing shorts
It's costly and dangerous to sell stocks short. While a stock can theoretically rise to infinity, rewarding investors along the way, a short-seller's potential profit is limited by the specter of bankruptcy -- a stock can't fall below $0 per share. Moreover, short-sellers are responsible for dividend payments, and over the long term, the market tends to rise, lifting nearly every stock up in the process. If a stock you've sold short rises, you could be on the hook for buying shares at a price way above what you sold your borrowed shares for.
A stock with a high short interest suggests there's a large amount of people with a fairly strong level of conviction betting against the company. That's not to say they're right, but investors should approach these firms with a greater degree of caution.
Sam Mattera has no position in any stocks mentioned. The Motley Fool has the following options: long January 2017 $35 calls on American Airlines Group. The Motley Fool recommends Yelp. 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.