As an active investor, I am always looking for profitable ways to screen, study and implement new trades. Over time, I've built a toolbox of high-probability scenarios that I revisit from time to time, hoping to uncover a stock or idea that checks each box on my list.
When looking to take long positions in stocks, one of the key measures I look at revolves around something known as short interest. It's a fairly basic metric that relates how many shares investors currently hold short positions in a stock. In general, the higher the short interest, the greater the negative outlook on the stock -- but a high short interest doesn't necessarily mean the stock is trading low.
Similarly, a related metric, known as days to cover, divides the short interest by a stock's average daily trading volume. If Stock ABC has 10 million shares short and trades an average of 2 million shares a day, it would take five days to cover that short interest.
Why is this important when buying stocks? One potential result from high short interest is something called a short squeeze, which occurs when a stock runs up and forces those short shares to be recovered.
As investors buy to cover their positions, the stock continues to run higher, propped up by all of that additional buying. This can result in a pop of epic proportions. (In fact, my colleague Marshall Hargrave just profiled five stocks that could be poised for just such a jump.)
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Keeping that in mind, I've identified two stocks with noteworthy days to cover, all while exhibiting growing revenue and earnings and high analyst price targets. I expect this combination will result in a stock or two that rise significantly in a short time.
Insurer AmTrust Financial Services (Nasdaq: AFSI) emerged on the positive end of my testing. From February to the end of April, AFSI has seen its days to cover creep up from 9 to 26 on falling daily share volume. The stock is currently trading around $42 (which happens to be its short-term support), already having reached a new 52-week high in mid-May. Analysts are looking for an average price target just shy of $50 in the future, representing a possible 19% gain.
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The start of May gave way to AmTrust's first-quarter earnings report, which beat expectations for revenue and earnings. Income investors will be happy to see a 1.8% dividend as well. Investing in AFSI means you're in good company -- billionaire Ken Griffin of Citadel Advisors has a debt position amounting to nearly $75 million.
The legendary firearms maker Smith & Wesson (Nasdaq: SWHC) happens to be a favorite among analysts, seeing upgrades in the past few months from several firms. The average one-year price target on SWHC is about 13% above current levels.
Smith & Wesson beat expectations on earnings (but narrowly missed on revenue) at the beginning of March. Management raised its full-year revenue forecast, which sent SWHC surging. From a technical perspective, SWHC tested its 52-week high of $16.20 three times in May. With a days-to-cover ratio of 15.6 at the end of April, a new 2014 high could be achieved quickly and drastically if shorts exit quickly upon the break of that ceiling.
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Risks to Consider: Remember, personal convictions and probabilities are just that -- they don't necessarily mean that a stock will move in the direction you want it to. The world's best hedge funds move capital into positions after rigorous testing from every angle, and even they aren't always right.
Action to Take --> Combining strong studies can whittle down a large list of stocks into a few stars that deserve a deeper look. AmTrust Financial Services and Smith & Wesson both have the potential to see new highs soon if short sellers start scrambling to cover.