High Short Interest: Warning or Opportunity

Investing Daily Article of the Week

by Jim Fink, Investing Daily

Short sellers sell stock that they don’t own in the hopes of buying it back for a much lower price at a later date. Several studies have concluded that short selling reduces market volatility and improves liquidity.

For example, Yale professor Owen Lamont wrote in Go Down Fighting: Short Sellers vs. Firms (2004):

Many of the sample firms are subsequently revealed to be fraudulent. Thus the short sellers are identifying firms having bad fundamental value. This paper has presented a rogues gallery of shady characters, ranging from Charles Keating to Adnan Khashoggi. In public battles between short sellers and firms, short sellers usually are vindicated by subsequent events. The evidence suggests that short sellers play an important role in detecting not just overpricing, but also fraud. Policy makers might want to consider making the institutional and legal environment less hostile to short sellers.

Lamont discusses examples of companies that sue short sellers for stock manipulation and found that such companies underperform the general market by 25 percent in the year following their lawsuits. His advice is to avoid companies that sue short sellers. All one has to do is look at the price performance of companies such as Solv-Ex, Overstock.com, and Biovail – now part of Valeant Pharmaceuticals (NYSE: VRX) — after they sued short sellers to conclude that short sellers were right.

Long-only stock buyers should welcome short sellers because their selling pressure lowers the price of stocks and makes them more affordable to purchase. Furthermore, when short sellers cover their positions (i.e., buy back the stock they initially sold) their buying pressure increases the value of the stocks already owned. What’s not to like?

Short Sellers are the Smart Money: Pay Attention to Short Interest Ratios

The benefit of short selling goes beyond increased trading liquidity, however. It turns out that short sellers are on average an extremely smart group of equity analysts and it pays to be aware of what they are shorting. You’ve got to be smart to survive as a short seller given all of the impediments regulators place in their way, not to mention the hostility of companies that sue them and the risk of short squeezes when lenders of stock decide they want the stock back. The Economist magazine calls the life of a short seller “nasty, brutish, and short.” But the best short sellers survive and thrive and are considered the “smart money.”

A 2004 MIT and Harvard study entitled Short Interest and Stock Returns concluded that

Our results indicate that the only class of stocks that reliably produce negative abnormal returns is that of small cap firms with extremely high short interest ratios. An investor selecting stocks for a portfolio should avoid stocks with a high short interest ratio. If an investor already owns a stock that develops sustained high short interest, the clear and strong advice is to sell the stock immediately.

“Short interest ratio” is defined as the number of shares shorted divided by the number of shares available for trading (i.e., the public float). The study found that stocks with the highest short interest ratios (99th percentile) underperformed on average by 125 basis points per month (15% per year). To qualify for the 99th percentile, the stock typically has a short interest ratio of 20% or higher. You can find the short interest for any Nasdaq stock by clicking here. The NYSE appears to charge for the most up-to-date short interest information (Bloomberg gets delayed data), but that’s okay because the study found that the negative relationship between short interest ratios and subsequent performance is strongest with Nasdaq stocks.

Stocks with the Highest Short Interest Ratios

Below is a list of the 10 stocks with a market cap of at least $250 million that have the highest short interest ratios. The data was collected in February 2013.

Source: Bloomberg

Short sellers aren’t always right, so some of these stocks might turn out to be good investments. But with this significant short-selling chip on their shoulders, avoidance is the easy solution for investors. Brave souls looking to profit from a short squeeze can consider buying in, but substantial due diligence research is recommended prior to pulling the trigger.

At my Roadrunner Stocks small-cap investing service, I respect high short interest ratios, but also have the confidence to go against the short-seller crowd when I feel they are wrong. When short sellers are wrong, they are really wrong and short squeezes can cause stocks to skyrocket higher. Right now, three Roadrunner recommendations have short interest ratios above 20 percent that I believe are excellent businesses with short-squeeze potential.