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New Year's Opportunities

|Includes:AmTrust Financial Services, Inc. (AFSI), EBIX

At the end of every year, I go about finding out which stocks have been hit hard by tax related selling and are ready to bounce back once the selling pressure is exhausted. There are always a few that you could make a case for being oversold. However, given the whopping gains in stock markets this past year, very few stocks fit that muster.

Since we've had very few stocks that have been oversold, I went looking for stocks that fit another similar condition - short squeeze. A short squeeze happens when too many people borrow a stock and sell it, in order to buy it later when its price has been driven down. In other words, too many people try 'sell high - buy low' playbook.

Normally, there are always a few people in every company's stock that are betting this way. The important thing to remember is that they need to buy the stock in order to complete their trade (the 'buy low' part of the 'sell high - buy low' playbook). You can find out how many shares are sold short by looking at that stock's 'short interest'.

An interesting thing happens when too many traders play this trade - as traders try to close their trades, their attempts to buy the stock sends the stock price higher - specially so if there aren't enough sellers. At times, this rise in stock price perpetuates itself as more and more short sellers abandon their trade because higher stock price incurs them losses. This increases buying pressure, which increases share price, which forces more short sellers to abandon their positions. This situation is called a 'short squeeze'.

A way to gauge if a stock is ripe for such a squeeze is to look at it short interest relative to its trading volume. If a short interest is a 1,000,000 shares and daily trading volume is 100,000 shares, then it is clear that for all shorts to close their trades, it is going to take about 10 days - assuming that trading remains normal for those 10 days and all shares are sold to cover borrowed shares. This interval is called 'days to cover' ratio. The longer the days to cover ratio, the higher probability of a short squeeze.

But in general that is not enough for a short squeeze - this is because the short sellers are no fools. They make short bets based on an educated guess that the stock deserves to trade lower. The trick lies in finding out when that guess is wrong.

This is why I try to find companies that are ripe for short squeeze by looking at short interest as well as their business fundamentals. If the company has a long term viable business that has only had a hiccup, then there is a good chance that short sellers would be proven wrong.

Screening through these two filters, in last week of December, I settled down on two - AFSI and EBIX.

AFSI (Amtrust financial services) seems to have been targeted for short selling. There is a rumor that the company isn't following sound accounting practices in its European units. The management is fighting this rumor. Now, I don't really know whether the rumors are going to be proven right; but I have seen this story being played out before, and it smells like the management position holds water. Also, this is a financial services company, and given all the regulatory hoopla about financial services industry, it is likely that the company is quite compliant with regulations. The stock has dropped 25% since the rumor started, so it is likely that it would recoup the losses and continue its upward march if the rumors are proven wrong.

I have watched EBIX trade in past. I never invested in it because I always thought that the valuation was too stretched for a small niche business like EBIX. But given its current valuation at PE of 9, I think it is cheap, even accounting for the relative drop in EPS. Combined with tax loss selling and too much short interest could result in a short squeeze in near term.

For those of you who want to pull the trigger on these stocks - remember these are not long term investments. The short squeeze catalyst will quickly evaporate if the short interest moderates; and while the company fundamentals look OK to me, they aren't that great - specially for EBIX. You might be better off in other stocks if you care to invest for any term longer than a few months.

Disclosure: I am long AFSI.

Stocks: AFSI, EBIX