Randy Newman had it all wrong. Short people really do have a reason to live. By short people, of course, I mean those who think that a stock is going down and are willing to put their money where their pessimistic mouths are. I admire their conviction. I love the fact that the market lets you pick sides. However, as someone who hasn't shorted a stock since I got all gloomy over Einstein Bagels in the 1990s, I would rather take advantage of the bad news bears than join them.
Every month the exchanges reveal the outstanding short positions on every listed stock. If you happen to own a stock that is heavily shorted, this shouldn't necessarily alarm you. Opinions are like noses. Everyone has one, and not everyone is right. If you understand how the shorting process works, and don't agree with those who think a company is going down the tubes, there might be a good opportunity at hand.
Here's how shorting works. An investor borrows shares from a broker and sells them. The investor then buys back the stock later on to return the borrowed shares, or "cover" the short. If the stock falls in that time, the shorts come out ahead. If the stock goes up, the shorts are out of luck, and worse, the loss potential is unlimited if the stock keeps climbing. Given the speculative nature of shorting, shorts tend to have itchier trigger fingers than long-term investors. They are often quicker to cut their losses if the stock isn't moving their way. That can spell opportunity for investors who have a more positive view of the shorted stock.
Profiting from the pessimism
This week I will take a closer look at three of the more actively shorted stocks. The sheer volume of shorts isn't all that important. After all, Sirius Satellite Radio
Instead, I'm looking at stocks with unusually high short interest ratios. What is that exactly? Here's an example. Right now, the Nasdaq stock with the highest short interest ratio is SCO Group
So Sirius may have a lot of shares sold short, but it could be wiped clean in just two trading days. The three companies that I'll highlight would take weeks to clear out the shorts -- and that's a good thing if you are long the stock and feel that solid fundamentals will trigger a change of heart from those betting against the company.
Now, dot-coms are often easy targets for punditry. The competition is just a click away. The barriers to entry are low. Many Web-based outfits are deficit-ridden early in their growth cycle. But not Blue Nile. It has been wildly profitable for quite some time. The fact that sales have grown at a healthy clip vindicates the model. The engagement ring buying process can be intimidating, and as consumers become more comfortable with shopping online, Blue Nile will continue to inch forward as a way for prospective grooms to receive high-end rings at discounted prices. So let the shorts object from the back pews. They will feel awfully lonely when they aren't invited to the hopping reception afterward.
With 2.9 million shares sold short, it would take three weeks of average daily volume to clear out the shorts. Maybe they have a sense of nostalgia. Tonight eCollege will be back where it was a year ago -- talking about its June quarter results. Last year, the stock got butchered, so it's easy to see why the shorts are rallying around this reunion. However, it's a bit different this time. For starters, the pessimism is already priced in the stock, and it is trading far below last year's highs. Earnings are already expected to dip so there may actually be more upside in the company's report than the market expects. Since the March quarter of 2003, the company has been consistently profitable, so as long as we're not talking about a dip into the red tonight, eCollege is unlikely to flunk out anytime soon.
The concerns here are mostly on valuation. Back in June, the company guided investors to expect this fiscal year's earnings to come in between $0.77 and $0.79 a share. Fetching 33 times that multiple doesn't make the maker of automatic card shufflers and table games seem exactly cheap. However, this is more than just a quickly growing company. It has also managed to come in slightly ahead of its profit targets for seven straight quarters. That's not the kind of trend that I would bet against -- especially with a company that, quite literally, holds all of the cards.
Short positions don't accumulate by accident. Sometimes the pessimism is contagious -- eCollege rival and Hidden Gems pick Blackboard
Still, the more you learn about a particular company and what makes it tick, the easier it is to envision a scenario where the company sends the shorts scrambling to cover. Misunderstood companies can be great investments. Blue Nile is an active recommendation in our Rule Breakers dynamic growth newsletter service. The average stock pick has more than doubled the market's return, so you may want to consider a free 30-day trial subscription to see if the Rule Breakers team inspires you to join me in telling Randy Newman to take a hike.
You've got a friend in me.
Longtime Fool contributor Rick Munarriz always seems to be short on time. He does not own shares in any of the companies mentioned in this story. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. The Fool has a disclosure policy .