How Short Sellers Can Help You Pick Winning Stocks

Includes: IDTI, MS, WYE
by: Dan Knight

The proliferation of hedge funds over the last 5+ years has led to a dramatic increase in the amount of short selling. Traditionally, if an investor didn't like a stock, he could either sell it, if owned, underweight it relative to a benchmark or just not own it. Shorting allows an investor to make an unconstrained active bet against a stock, either speculatively or as a hedge.

During this time, short sellers have by in large correctly identified relatively under- and over-valued stocks. Among the top 1500 US stocks by cap and on a monthly basis, the least shorted stocks have done slightly better than the average stock and the most shorted stocks have done worse than average. Thus, the short sellers are demonstrating some skill and relative valuation insight.

To exploit this insight, you can look for the least shorted stocks and a simple definition of cheapness, the forward P/E, and narrow your focus on those stocks in the bottom 20%. Short sellers are good in this "value" quintile of the market at identifying relative under- and over-valued stocks. Here, the 20% of stocks least shorted, that is the value stocks that the short sellers least want to bet against, have done better than the average stock by about 0.5% per month, or 6% per year, and better than the 20% most shorted value stocks by an average 0.75% per month, or nearly 9% annually. These are significant results.

Some current value-oriented names that have low short interest are Integrated Device Technology (NASDAQ:IDTI), Morgan Stanley (NYSE:MS) and Wyeth (WYE), all up so far in this month in a down tape. Of course SLM (NYSE:SLM),  Xerox (NYSE:XRX) and Citigroup (NYSE:C) are three value names with low short interest that are down this month, so the technique isn't foolproof, but at least it's a good first cut to help find attractively priced names that aggressive investors think have enough upside potential to not bet against.