Let me start by saying this: I learned my lesson last quarter. On the eve of earnings season, I went looking for six innovative companies with a high number of shares being shorted, and posited that because of this, they could double over the following months.
How did they do? As a group, they have averaged a loss of 35% -- against the S&P 500's loss of 8%.
A new approach
Instead of hyping the stocks I'm about to talk about by telling you that they could double over this earnings season, I'm just going to say that there could be lots of movement -- up or down -- this time around.
But before I get to the stocks, here's a quick summary of what it means to short a stock.
Here's a 30-second guide to how it works:
Mark decides that Blue Horseshoe's stock -- which is trading for $10 -- is going to fail.
Mark goes to Alli, borrows Alli's 10 shares of Blue Horseshoe, and sells them on the open market, pocketing $100.
Mark waits for Blue Horseshoe's shares to drop. Once they get down to $5, Mark "covers" his shares by repurchasing them on the open market.
Mark gives the 10 shares back to Alli. Because he pocketed $100 from selling the shares, but only paid $50 to get them back, Mark has made $50.
But if Mark was wrong, and Blue Horseshoe's shares go up, he has to decide to either cover his shares at a loss, or wait until a later date for shares to go down. That's where shorting can create what's called a "short squeeze," where all the shorters attempt to cover at the same time.
I went looking for the 10 stocks with a huge number of their available shares (their float) being shorted. Here's the list, as well as a very quick summary of what they do.
What It Does
Travelzoo (NAS: TZOO)
Travel and local deals
SodaStream (NAS: SODA)
At-home soda makers
Zagg (NAS: ZAGG)
Accessories for electrical equipment
Chinese industrial electric equipment
Tesla Motors (NAS: TSLA)
ATP Oil & Gas (NAS: ATPG)
Oil and natural gas
Bags, handbags, and purses
Northern Oil and Gas (ASE: NOG)
Oil and gas
OCZ Technology (NAS: OCZ)
Data storage devices
Source: Wall Street Journal. As of Sept. 30.
What to look for
I don't think investing in any of these companies without completing your own due diligence is a good idea. One step to getting started is to take a look at when this quarter's earnings statement is, and what kind of numbers the company is expected to put up.
How a company's earnings are in relation to expectations, as well as what kind of guidance they offer for future earnings are the two drivers that usually move a stock directly following an announcement. Below are the dates and earnings expectations for these 10 companies.
Expected Earnings Release Date
Analysts' EPS Estimate
ATP Oil & Gas
Northern Oil and Gas
Jan. 10 (2012)
If it seems like the gist of this article goes against the Fool's buy-and-hold mantra, you're on to something. I would only suggest buying a company's stock that you have faith in over the long term (or shorting one that you don't have faith in over the long run).
But if you buy or already own one of these stocks, you should be prepared for the choppy waters ahead that short-sellers have created.
If buying quality businesses that are heavily shorted fits within your motley approach to investing, then I suggest you take a look at one of our special free reports: "The Motley Fool's Top Stock for 2011." Inside, you'll find out about a company that not only is set to profit from broadband Internet expansion, but also has a current short interest of 11.8%. The report is yours today, absolutely free!
At the time thisarticle was published Fool contributor Brian Stoffel owns shares of Travelzoo and SodaStream. You can follow him on Twitter at @TMFStoffel. Motley Fool newsletter services have recommended buying shares of Travelzoo and SodaStream International. 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.
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