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A few days ago I wrote an article about Outerwall (OUTR) based on a report by Goldman Sachs (GS) that shows 50 companies that were heavily shorted by hedge funds. But they not only outpaced the S&P 500 this year, but as a group they have produced average total gains of 30%. I chose Outerwall simply because it was the first company on the list; meaning the most heavily shorted of all 50 companies. What I realized after researching that company is that this list is a literal gold mine for investors looking for long and/or short positions in the market. Another company that is heavily shorted by the hedge funds is GameStop (GME). Here is that list which begins with the most shorted stocks as a percent of market cap:

CompanyTickerMarket Cap (in Millions)# of Hedge Funds Owning StockTotal Return YTDShort Interest as % of Market Cap
Outerwall Inc.OUTR1,7733322%38%
Cliffs Natural Resources Inc.CLF3,63729-37%36%
BlackBerry LimitedBBRY5,74238-8%35%
NII Holdings, Inc. Class BNIHD1,09725-11%34%
WhiteWave Foods Co. Class AWWAV2,0152623%33%
United States Steel CorporationX2,73328-20%32%
Sarepta Therapeutics, Inc.SRPT1,0742424%31%
Herbalife Ltd.HLF6,72342102%31%
CARBO Ceramics Inc.CRR1,9901611%31%
Sodastream International LtdSODA1,3171542%31%
Liquidity Services, Inc.LQDT1,03412-20%30%
Francesca's Holdings CorporationFRAN1,04518-8%30%
VIVUS, Inc.VVUS1,26234-7%29%
Fusion-io, Inc.FIO1,06227-53%29%
Pitney Bowes Inc.PBI3,5202872%29%
Arena Pharmaceuticals, Inc.ARNA1,54710-21%28%
Radian Group Inc.RDN2,24839113%27%
Heartland Payment Systems, Inc.HPY1,4101430%27%
3D Systems CorporationDDD4,7012630%27%
World Acceptance CorporationWRLD1,0061415%27%
PHH CorporationPHH1,25734-3%26%
Deckers Outdoor CorporationDECK1,9423440%26%
Western Refining, Inc.WNR2,4953612%26%
Molycorp, Inc.MCP1,18620-33%26%
Polypore International, Inc.PPO1,90015-9%25%
Questcor Pharmaceuticals, Inc.QCOR3,99429153%25%
DreamWorks Animation SKG, Inc. ClassADWA2,1311770%25%
GameStop Corp. Class AGME5,6103394%25%
j2 Global, Inc.JCOM2,3541369%24%
Equinix, Inc.EQIX8,19872-20%24%
Frontier Communications CorporationFTR4,6792515%24%
US Airways Group, Inc.LCC3,0196416%24%
Interoil CorporationIOC3,6172533%24%
Vistaprint NVVPRT1,7491062%23%
athenahealth, Inc.ATHN4,0151549%23%
U.S. Silica Holdings, Inc.SLCA1,2212838%22%
IMAX CorporationIMAX1,7971819%22%
American Equity Investment Life HoldingCAEL1,2472058%22%
R.R. Donnelley & Sons CompanyRRD3,24326112%22%
Universal Display CorporationOLED1,6711341%22%
Air Methods CorporationAIRM1,5891711%22%

The 708 hedge funds that were included in the study had $1.5 trillion invested, with $1 trillion long and $500 billion short. The first thing that investors need to keep in mind when shorting a company is not to ever short a company simply because you think that it is overvalued. Look for real quantifiable problems.

Does GameStop have problems?

GameStop is a Fortune 500 and S&P 500 company, and it is the world's largest "multi-channel video game retailer". Its world wide retail network and family of brands include 6,544 company-operated stores in 15 countries and online at www.GameStop.com. At first glance, the company is up almost 200% for the year compared to the three major market indices:

Chart forGameStop Corp.

Gamestop reported Q2 earnings on Thursday which were down compared to the same time last year, but beat guidance due to bigger margins. The company also repurchased $88.9 million worth of its own shares, and announced a dividend that will be payable next month on September 19:

During the second quarter of 2013, GameStop repurchased approximately 2.39 million shares at an average price of $37.21, or $88.9 million worth of stock. There is now approximately $311 million remaining on the existing repurchase authorization. GameStop's board of directors also declared a quarterly cash dividend of $0.275 per common share payable on Sept. 19, 2013 to shareholders of record at the close of business on Sept. 3, 2013.

It is always dangerous to short a company that is buying back its own shares, because the buyback can be structured to cause a short squeeze. In other words these companies buy their stock up until the shorts are forced to cover at a higher price when the options close. Then the price usually will fall and the company can start buying again. It is a vicious cycle for a short investor, but the bulls love it.

GameStop expects comparable store sales and earnings to be up for Q3 due to "positive trends" in console pre-orders. And with the strong Q2 results the company raised its full year guidance which does not include the positive change in earnings per share that will occur with more buybacks later this year.

The new consoles due out in November from Microsoft (MSFT) and Sony (SNE) are expected to be much stronger products than the last launch. Which company will win this console game war? It is hard to know right now, but GameStop CEO J. Paul Raines said on the company conference call that this will be the largest console launch in history:

The unique value of the buy-sell-trade model has been reaffirmed by our partners and will bring over $1 billion per year of trade currency to consumers for their new console purchases. Tony Bartel will share some of the highlights of our U.S. performance with you later on the call, as well as giving you some insight on how we will execute what will be the largest console launch in history.

According to Gamestop President Tony D. Bartel:

For the console launches, our allocations from both Microsoft and Sony are much stronger than last launch. While we cannot disclose actual launch quantities for competitive reasons, we expect a significant increase in launch day quantities versus the last console launch. To put the launch efforts into perspective, we have increased our launch period supply chain capacity by 60% through the use of contracted distribution centers. By utilizing our reservation information and PowerUp Rewards first to know list, we will be able to pinpoint these unprecedented launch quantities to the right locations and to drive logistic savings as well. After completing our reservation programs for both consoles, we still have 1.5 million of PowerUp Reward customers on the Sony first to know list, and 700,000 PowerUp Reward customers on the Microsoft first to know list.

(click to enlarge)

Microsoft Xbox One

The Day One Edition includes a commemorative controller, Xbox One chat headset, an exclusive achievement, and special-edition packaging. Right now it can be pre-ordered for $499 which insures that the purchaser will be one of the first people to experience the new limited edition console.

(click to enlarge)

Sony PlayStation 4

The Playstation 4 can be pre-ordered for $399 which is $100 less than the Xbox One. This may make a difference for some gaming consumers. But no matter which one sells better, GameStop will have them both. According to statements from Bloomberg Bussinessweek Technology on Monday, Raines expects profit in the coming quarter to be up 45%:

Before the next-generation devices arrive, there's likely to be a final retail hurrah for new games on the old machines as the hit franchises Grand Theft Auto 5 and Battlefield 4 hit the shelves over the next two months. There are no other retailers on the planet that are prepared for this kind of opportunity," GameStop Chief Executive Officer Paul Raines bragged to investors about the coming of the new consoles. The company expects profit in the coming quarter to be up to 45 percent from the year-earlier period. If history is any guide, GameStop is in for a wild ride.

In spite of this, the short investors are banking on GameStop failing. The latest short interest, which was released Monday for August 15 is 19.78 million shares, which is still 17.2% of the float. Based on the current average daily volume of 2.2 million shares, it would take 9 days to cover. The short interest has dropped quite a bit from the 25% on the Goldman Sach's list (above), but that is still a sizable amount of shares sold short. As I have said in the past, a lot of short investors hold on to the hope that the shares will finally come crashing down. Sometimes they do, and sometimes they don't, which gives the GameStop Bulls a reason to celebrate as the shorts are forced to cover millions of shares forcing the price even higher

Although the company has had a tough year fundamentally with some negative earnings, the forward P/E is under 14. Investors have evidently been patiently waiting for these game consoles to be released. And now the news they had hoped for is out. Since the conference call, analysts have been scrambling to revise their estimates upward. In the last week, the Oct 13 quarter earnings estimates have jumped 12 cents a share:

Estimates for GameStop

EPS TrendsCurrent Qtr.
Oct 13
Next Qtr.
Jan 14
Current Year
Jan 14
Next Year
Jan 15
Current Estimate0.472.223.193.79
7 Days Ago0.352.333.153.75
30 Days Ago0.352.323.153.74
60 Days Ago0.352.323.143.71
90 Days Ago0.372.293.093.66

It is interesting to see that there have been no revisions in estimated earnings for Microsoft or Sony, the manufacturers of the Xbox One and PS4.

Chart forGameStop Corp.

Will Xbox One be enough to pull Microsoft out of its current slump? Both Sony and MSFT investors should watch how the consoles are selling, because both of those stocks could take off if holiday sales jump dramatically. Even though the future sales appear to be baked in to the GameStop shares, the company buyback program combined with a short squeeze could send the stock even higher with all of this good news.

Source: Will GameStop News Sink The Shorts?