Short interest is often used as a contrary indicator by bullish investors because shorts in theory will have to bid the price up when they buy to cover existing positions. However, is the short squeeze hypothesis valid? Several academic studies by professors at MIT and the University of Florida indicate the contrary, as companies with short floats above 20% on average underperform the market by 215 basis points per month. There is also a negative correlation between the short float amount and expected future returns.
If that is the case, what are some opportunities on the short side that involve companies with high short floats? Here is the list of three stocks with some the highest short floats on either the NYSE or the Nasdaq. I will go into a more detailed analysis on each company, but it looks like the common theme of these companies is that they have eroding economic moats or a gimmick product.
Travelzoo (TZOO): Travelzoo is a travel site that lists links to other travel's firms websites to spot the best deals (basically the Groupon of travel). The first thing that comes to my mind with Travelzoo is the lack of barriers to entry in its business and the lack of unique deals that competitors, such as Priceline (NASDAQ:PCLN), have.
Travelzoo also requires a subscription (free, but people do not like being bothered by e-mails) for access, while competing travel search engines, such as Kayak, are more comprehensive and do not make customers join an e-mail list. With a 73% short float, it seems like institutions do not believe that the business can continue to grow at the current estimates. With the price near 52-week lows, I would not short here, but a break below support at $20 per share can cause a freefall.
Skull Candy (SKUL): With a short float of 55%, institutions seem to be betting against the company's long-term growth prospect. The company primarily sells headphones, but also produces some other smart phone accessories. Skull Candy faces similar problems to competitors ZAGG (NASDAQ:ZAGG), Belkin, and Targus in the fact that it has to create high margins from a largely commoditized product. Competition from Monster Cable's Dr. Dre Beats headphones has reduced the value of Skull Candy's brand equity as well.
I still see Skull Candy as a long-term leader in the headphone industry, but pricing pressure will lower its long-term growth. I think the fair value of this company is somewhere between $11.50-13.50, but that is dependent on the Skull Candy's ability to maintain a portion of its brand equity.
Sodastream (SODA): Sodastream produces a home carbonation machine that allows customers to make sodas at home. It has been one of the most volatile stocks in the market, and with a 56% short float, one of the biggest attractors of institutional skeptics. I'm with the bears on this one for a number of reasons.
First of all, 62% of sales come from struggling Western Europe. Also with the cheapest of Sodastream's machines starting at $80 and with bottle of soda selling for $1.25 at fast food restaurants or grocery stores, a consumer would have to buy at least 64 bottles/cans for the purchase of the machine to break even in value. That estimate does not even factor the cost of buying the flavoring syrups which need to be replaced every 12 liters. I may be biased because I tend to limit the amount of junk food I eat, but drinking 64 sodas a year at home sure seems like a lot. Especially, with the population of the US and Europe growing more health conscious (at least within the demographics that can afford to buy a Sodastream soda maker), I expect Sodastream sales to slow down significantly.
Overall, among these most heavily shorted companies, a short squeeze buying opportunity for a time period beyond a few days is highly unlikely. If there are a large number of institutional investors who are willing to risk capital and pay high borrowing costs (sometimes up to 25% annually for a hard to borrow stock) to short most of the company's float, they probably have enough fundamental conviction to hold their positions beyond the next major uptick. I do not recommend buying any of these companies currently, but I believe that Sodastream is a good long-term short.
*Thompson Reuters source for short float.
Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SODA over the next 72 hours.