When buying stock, two common rules are to keep away from very high Price / Earnings ratios, and to keep away from very high Short Interest (the percent of shares that have been sold short). High P/E means a stock probably trades for more than it’s worth. High Short Interest means many people expect the price to fall.
Strange as it may seem, investors buying stock with both a very high P/E and a very high Short Interest often make big profits. Here’s why, plus three stocks that show how.
Stocks usually stick with their long-term trends. If a stock has been going up for a long time, it’s likely to keep going up until some decisive bad news or a bad market pulls it down - routine volatility and pull-backs excluded.
The 200-day moving average of a stock defines its long-term trend. This is the average price for the last 200 trading days. Each day a new price replaces the price from 200 days ago, so the average “moves.” Any charting software will show you a chart of the 200-day moving average compared to daily price.
If a stock has traded above its 200-day moving average for at least three months, it’s in a confirmed up trend.
Now here’s a money-making trick when buying stock: look for stocks in a confirmed up trend that have a P/E of at least 50 and Short Interest of at least 15%.
This seems to go against all the rules, but here’s why it works.
When people sell short, they borrow stock from their broker, sell it, and hope to buy it back at a lower price before returning it. This is a loan – of stock, not cash – and the collateral on the loan is the money raised by the initial sale.
If the stock goes up instead of down, that cash collateral may no longer be enough to cover the loan. The short seller gets a “margin call” from his broker demanding he either put up more cash or buy back the stock immediately to repay the loan. Short sellers usually have no choice but to buy the stock to repay their brokers.
When lots of short sellers get margin calls at the same time, it creates a “short squeeze.” All those short sellers buying the stock force its price up. That squeezes still more short sellers, so the price goes up again. When there are lots of short sellers, and a stock price turns up, it can explode up because of a short squeeze.
That’s why we look for stocks with a confirmed up trend. There’s a good chance they’ll inch up some more. If there are lots of short sellers (Short Interest over 15%), they’ll get squeezed, pushing the price even higher.
Stocks with high P/E (over 50) attract short sellers.
That’s how you can make money buying stock which is “bad.”
Now here are three examples of this method at work.
Lululemon Athletica (NASDAQ:LULU) makes clothes for athletes. Its P/E is 51.95 and its Short Interest is 16.9%. It's traded above its 200-day moving average for over two years.
Cepheid (NASDAQ:CPHD) makes molecular testing equipment for medical and industrial applications. Its P/E is 979.5 and its Short interest is 14.6%. It's traded above its 200-day moving average for a year (two and a half years, if you disregard two brief dips).
Green Mountain Coffee Roasters (NASDAQ:GMCR) makes specialty coffees. Its P/E is 89 and its Short Interest is 14.2. It's traded above its 200-day moving average for a year.
All three stocks offer strong profit potential.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.