Coming soon to a stock market near you…
Spend enough time short-selling and you will get pretty good at spotting short squeeze candidates. The problem with this is that when you are short, it can often be very challenging to switch sides because you have usually adopted quite a negative view of the company in question. But if you can detach yourself from this view, there is good money to be made leveraging your knowledge in a stock you have been shorting playing a violent squeeze rally.
In fact, if you exclude options activity, a great short squeeze almost always offers a better percentage return opportunity than patiently shorting a stock. Right now, I am sniffing out such an opportunity emerging in Deckers (NYSE:DECK) shares.
Decked by Deckers
I'll admit, as a short-seller, I have not had many good experiences with Deckers. Now, you might be wondering how that is possible considering the decline in the stock over the past year, but it is true. Most traders/investors when it comes to shorting will tell you about their great successes, but in my case the trades that remain freshest in my memory are the total failures. And when it comes to those experiences, I can recall every last detail.
See, you usually don't learn much when something works right away, but when you are shorting a strong stock and it is not working, you tend to learn a lot because the position turns into a test of endurance. It's like running in a market marathon, your success hinges more on your mental fortitude than your bank roll. Was I too early? What's the difference between too early just meaning I was wrong, and too early meaning early but right? When does stubbornness become stupidity? And when does performance frustration overcome sound analysis and conviction? If you have a good deal of short-selling experience, you probably have asked yourself these questions.
I first shorted Deckers in 2007 thinking the Uggs brand was a total fad. It was a relatively medium sized position as most of my short selling attention was being focused on Crox (NASDAQ:CROX), but I still liked it a lot. After about a 30% loss in a month and a half, I covered. I really didn't have a good reason for exiting other than the fact that I was getting even more crushed on my CROX short and saw more reward in that position. Basically, I had to cut and take a loss on something and Deckers was it. I then pretty much shelved the name for the next four years.
When I finally came back to it in 2011, the stock was almost double where it had been when I first shorted it in 2007. But this time around my thesis was a bit different than a simple fashion fad blowup. I was focused on rising input costs, namely sheepskin prices, and battering margins. I opened what I felt was a decent sized initial short position at $65 and watched the stock climb 30% within a few weeks. Nobody seemed to care about rising raw material costs, and I really didn't have much more to go on than that. So, after a small dip, I covered again with a loss. But I hate giving up on a thesis I feel is right despite a lack of overwhelming evidence, so I came back a month later.
This time my timing was lucky and the stock fell 15% almost immediately after I initiated my position. Of course that didn't last long, within a month the stock reversed and was on its way to a new all-time high. This was despite increasing evidence that raw material costs were becoming a more serious problem. So, instead of shorting more at the peak I sat tight and when the shares got back to my cost basis I covered. I figured, as many others before often have, that I'd wait for a bounce and just buy some six month OTM puts on the name to limit the takeover risk that seemed to be emerging in the space.
Problem is that bounce never came, and the stock has been in a free fall ever since. And this is a mild short-seller failure story because I never was too excited about the idea. The market cap wasn't big enough to sufficiently mitigate brand acquirer risk, the fad argument was flimsy, the valuation never that extreme, and the management seemed very competent. Compare that to a name like FSLR which I shorted many times in its bubble days on what I felt was a bullet proof thesis, and missing out on Deckers doesn't sting nearly as much. But I still hate to watch a stock I was once shorting collapse without me in it, so I try and stay on top of the story looking for an edge to exploit at some point.
Squeezing your Edge Out
Learning about a company, industry, and what's driving a stock on a quarterly basis requires a significant time investment. And there is an opportunity cost issue when you are shorting because you are often choosing between certain companies or industries and trying to hit a narrow window. Not capitalizing on one is usually compounded by also missing out on another stock you had a strong view on. Hence the desire to flip the trade and use your knowledge to make money in the other direction.
A good short squeeze like Netflix (NASDAQ:NFLX), Nokia (NYSE:NOK), FSLR, Green Mountain Coffee (NASDAQ:GMCR) have gone through at times over the past year can move the stock of a company with major fundamental issues 50%-100% in weeks. As a former short seller of all the aforementioned names, I have gotten pretty decent at spotting these moves and, when supremely comfortable, participating somewhat.
Here is what I look for:
1) A series of disappointing quarters culminating in a kitchen sink quarter from management that ultimately ends up having little permanent impact on the share price. Recent examples include First Solar and Green Mountain Coffee.
2) Favorable seasonality. This works well for retail stocks as longer-term issues can get overshadowed by temporarily favorable seasonal dynamics.
3) Played out short arguments, i.e., declining margins, oversupply, rising inventories etc. Once these become obvious to everyone or show the slightest hint of reversing, the stock becomes a coiled spring.
Presently, Deckers is exhibiting all three of these traits.
Kitchen Sink Quarter With a Muted Stock Reaction
Over the past two years, we have raised prices on selective key styles to help mitigate the impact of an 80% increase in our sheepskin and raw material costs over this same period," stated Angel Martinez, President, Chief Executive Officer and Chair of the Board of Directors. "We believe that these selective price increases, particularly during a period of one of the warmest years on record, has pushed us above the consumer's price-value expectations for the UGG brand. We also believe that this has resulted in softer than expected third quarter sell-through trends in our Company owned stores, and has pushed back the start of the brand's key selling season at retail this year. However, based on positive consumer feedback, the performance of new product introductions, and market research data, we continue to be confident in the strength and popularity of our brand portfolio and the multiple growth opportunities that still lie ahead.
When I read this paragraph the minute their earnings were released I knew that the cycle of quarterly disappointments had come to an end. No matter what Deckers reports next quarter, management has finally set expectations at a level low enough to build off of going forward. From a stock perspective that is critical if you are looking to flip sides or even just play a temporary and violent squeeze. And though the shares fell almost 20% on this news, the real story here was that in a mere six days almost all those losses were reversed. That tells you there was a good deal of short covering and no pile on momentum shorting.
Uggs boots are predominately a winter season purchase, and thus as we approach the holiday season the calendar flips in their favor. Add in that this past year was one of the warmest on record in North America and you get the nice added benefit of pent up demand to go with the seasonality.
Played Out Short Arguments
Deckers' big problem over the last 18 months has been a near 70% rise in sheepskin prices eating into margins and subsequently causing some pricing missteps that impacted demand. Both of these issues are reversing course with sheepskin prices slated to fall and management readjusting pricing on key Uggs downward to preserve long-term brand equity. Also, the inventory issue which I track religiously when I am shorting a stock like this seems to have peaked this past quarter and should return to more normalized levels.
Put all these factors together and you have a very solid case for being long the stock from now until their next earnings in January. And if you have studied past moves like this, your expectations should be for a 50% or greater increase of the bottom simply on short covering and shifting sentiment. Non-news driven moves like these are usually the most lucrative, so when I spot them I tend to get excited about the opportunity, and in Deckers' case, I am even more excited than usual because I think the Uggs brand is actually fundamentally healthy.
This makes things more interesting because going long doesn't just entail playing short covering, a temporary shift in sentiment, and bombed out expectations. At these prices you can argue that the stock is actually fundamentally attractive on a valuation basis and maybe even a great fashion brand acquisition candidate. That makes not watching the daily tape a lot easier, and the need to manage the position a lot less important.