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5 short-squeeze candidates
A short squeeze can drive a stock explosively higher when a trend goes from bearish to bullish.
By Jim Jubak
Volatility. One step forward and one step back. Up and down and then up again. Ceaseless movement without much of a net advance or retreat is what characterizes this market.
A good part of that is because this market is so dominated by computerized program trading. In the week that ended on June 25, computerized program trades accounted for more than 70% of all volume on the New York Stock Exchange. That set a new record, wiping out the one set the week before when program trades accounted for 56% of all NYSE volume.
Program trading is designed to capture profits from small discrepancies in pricing between, say, traded indexes and the baskets of individual stocks that make up the indexes. These trades keep the market in constant motion, but they dont produce long price trends, and in fact, mitigate them. A market dominated by program trading offers lots of sharp, short-term volatility but not much in the way of long-term direction.
All of which makes this a good time for trading strategies that attempt to earn the maximum profits from the markets constantly changing direction. One that is well-suited to this kind of volatility rests on reading the bets that short sellers are making that specific stocks will fall and then buying the very stocks that the shorts are selling.
A change in direction
If this market is about to shout About face! and deliver the kind of short-term rally that has so typically followed a short-term decline, then investors want to pay attention to the fuel that is available to drive individual stocks higher.
Ive talked about earnings surprises as one example of that kind of fuel. Another is more technical. A short squeeze can drive a stock explosively higher when a trend goes from bearish to bullish. Investors short a stock, selling borrowed shares in the hope that the price will plunge and theyll be able to replace those borrowed shares at a lower price. But they know that if the stocks price rises, theyll need to buy shares at a higher price. If a heavily shorted stock begins to climb, a wave of buying from shorts looking to buy and cut their losses can turn a relatively modest move into an explosive gain.
In other words, looking for short squeezes is a way to profit from the volatility of a market like this and to potentially magnify the size of the profits that investors can wring out of these short-term price moves.
The criteria
To find short-squeeze candidates youll need:
1. Data on how many investors have shorted a stock. The major exchanges regularly publish lists of the number of shares sold short. Its a good idea to process that raw data a bit. After all, what an investor needs to know is not just how many shares have been shorted but how likely that short position is to generate a move up in the share price in a short squeeze.
A 1 million share short position in a stock such as Lucent (LU, news, msgs) with 4.3 billion shares outstanding is a very different thing from a 1 million share short position in Drexler Technology (DRXR, news, msgs) with 11.4 million shares outstanding. One of the best systems I've seen for getting a read on short-squeeze potential comes from Phil Erlanger, editor of Erlanger Squeeze Play. Erlanger publishes a weekly list of likely short squeezes that give 30 stocks a squeeze rank based on how the current short position compares to the average short position over the last five years. A stock with a squeeze rating of 50% has a current short position equal to the five-year average.
Of the five stocks in this column, my three picks for CNBCs "Morning Call" and my two exclusive picks for CNBC.com on MSN, one has a squeeze rating of 100%, three are at 75% and one is at 63%, according to Erlanger. (Follow this link to check out Erlanger Squeeze Play.)
2. Data that allow you to identify stocks with powerful upward momentum, despite the short selling. Its that upward moment that will trigger a short squeeze if short sellers are wrong. You can get an accurate but easy to understand momentum grade on most stocks from our StockScouter. Check for the four-part breakdown of the overall rating to look for the stocks technical grade. All five stocks in this column get an A in this area from StockScouter.
The potentials
So here are my three "Morning Call" follow-the-shorts picks
Cytyc (CYTC, news, msgs). The short case against this seller of imaging systems, tests and supplies for medical diagnostic applications like the Pap test for cervical cancer rests on a study published in the Journal of the American Medical Association. The study said as many as 10 million women a year are receiving unnecessary Pap tests. If the number of tests administered goes down, so will Cytec's revenue and earnings. The bulls reply that various prestigious medical associations have called these tests unnecessary for this group of women for years, but physicians have kept administering them for good and bad reasons. So theres no reason to expect that theyll suddenly stop ordering the tests. Cytyc has a squeeze rating of 75% and gets an A from StockScouter on technical factors.
Applied Industrial Technologies (AIT, news, msgs). This company was a June 9 recommendation of mine. At that time, I noted that Applied Industrial operates in the market for fluid and electrical systems and components. Earnings per share are projected to grow by 55% in the fiscal year that ends this month and by 22% in the fiscal year that ends in June 2005, I wrote.
The short case here is built on the stocks rapid appreciation as much as anything else. Shares were up 29% in 2003 and another 26% so far this year. Also, the argument goes, the company raised guidance last quarter before it delivered a huge 31% earnings surprise, but this quarter the company has so far not raised guidance. There are worries about a slowdown hitting the industrial companies that are Applied Industrial's bread and butter, which is why the stock is attractive enough as a short to get a 72% squeeze rating. The technical grade from StockScouter is A.
Late in the cycle
Amerada Hess (AHC, news, msgs) (AHC). Its getting very late in the oil cycle to be buying oil stocks, say the shorts, especially when the higher price of gasoline is likely to reduce sales of refined petroleum products at the refinery end of integrated oil companies such as Amerada. The companys production is set to rise only modestly, if at all, this year and by just 3% in 2005. Despite this, the shorts point out that the stock is up 52% this year.
I think this ignores the stocks negative performance in 2001, 2002, and 2003, so in a sense Amerada Hess is making up lost ground. It also ignores the huge constraint on earnings that resulted from Ameradas efforts to hedge oil prices. Nonetheless, the short argument is strong enough to earn this stock a squeeze rating of 75%. The technical grade from StockScouter is an A
2 exclusive picks
Biomet (BMET, news, msgs). The shorts say that Biomets share price has run away from its fundamentals. The stock trades at 36 times projected earnings even though Wall Street sees earnings growth of just 15% in fiscal 2005 and 17% in fiscal 2006. That price-to-earnings ratio is not that much lower than the forward P/E ratio of 39 commanded by Stryker (SYK, news, msgs) with its appreciably higher earnings growth of 26% in 2004 and 20% in 2005. Biomet has the highest squeeze rating at 100% of the five stocks in this column. StockScouter gives it an A on technical factors.
Valero Energy (VLO, news, msgs). This is another valuation looking to collapse, the shorts say. The stock is up 64% this year and thats just too far, too fast for this refiner of sour crude oil. But this ignores the leverage that Valero gets out of being a specialist in this cheaper, more abundant, but tougher-to-refine grade of oil. That should be enough to drive return on capital to 14.5% this year from 8.9% in 2003, according to Deutsche Bank. And to go where the margins are, Valero is increasing its exposure to sour crude to 65% this year, up from 50%. The figure is projected to reach 70% in 2005. The stock has a squeeze rating of 63%, the lowest in this group, and a technical grade of A.
Oh, and short positions aside, our Scouter gives Cytyc a 10 out of 10, Applied Industrial a 9, Amerada a 9, Biomet a 9 and Valero a 10.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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