Finding Stock Buys Among the Shorts

• ByTim Melvin, RealMoney.com Contributor
• On 1:30 pm EDT, Tuesday July 28, 2009

One of the tables I make a point to look at each week when my copy of Barron's shows up is the one for short interest figures. A large short interest provides a natural pool of buyers in a stock, since unless the company files bankruptcy, the shorts have to cover sometime.

A short squeeze can drive a stock higher faster than anything else, in my experience. A large short interest is not in and of itself a reason to buy a stock. Most short-sellers are fairly smart men and women, and in most cases they have discovered a negative in the fundamentals. However I always keep my eye out for those situations where the bad news may be priced in or where there is some catalyst for change in the near term that may force the shorts to cover.

Some of my best trades and investments have come from seeds discovered in the short interest tables. Greentree Finance was heavily shorted when I bought it in the late 1980s. Business was terrible, and the shorts made a pile of money. What they overlooked as the stock plunged was that the company was over-reserved by a large amount. It went on to become one of the biggest winners of my career. Ames Department Stores likewise had a large short interest, and it became a 10-bagger in just two years.

Short interest is just a starting point, like stock screens. You have to do the homework, but it is a very good starting point.

Sometimes you find a stock with a huge short interest where the insiders are buying, setting up a classic tug of war. That is happening right now at CompuCredit Holdings. The shorts have gotten rich on this one as the stock has tumbled more than 90%.

This lender to those with less-than-perfect credit has been hammered by the credit crunch. It also had to pay a $112 million fine to the government over sales practices and customer disclosure. Delinquency rates on the subprime consumer and credit card loans are now over 17%. To call the situation ugly is insulting to ugly. In spite of this, there has been some insider buying and an eye-popping 97 days of average volume sold short.

If the company is able to make it through the recession without filing for bankruptcy, the shares could fly as shorts cover and take profits. I would not load up the truck, but a small position could turn into large profits over the next year or so. At this point the stock is basically an option on the company surviving. The first sign of any good news here will send the shorts scrambling. Some very sharp hedge-fund operators have apparently bet that the company will survive, as Citadel, D.E. Shaw and Renaissance have been buyers in recent months.

Stocks on the heavily shorted list tend to be ugly ducklings. When I look at this week's list, I see a lot of banks, REITS and of course newspapers. These are unpopular stocks in industry groups where conditions are terrible. I like the fact that the whole world is short New York Times Co.. I think the paper will survive, and at some point it is going to take 15 days average trading volume for the shorts to cover. In fact, short-covering was responsible for much of Monday's 10% move in the stock.

The fact that shorts are increasing their positions in airlines makes me like my Southwest Airlines position even more, as the short position grew by 13% in the past two weeks.

Always keep in mind that the short interest list is a starting point. A lot of the companies that are on there belong there. Absent a catalyst or rapid consumer recovery, a stock like Under Armour or Harley-Davidson is probably going to go lower before it goes higher.

At current levels, I could not give you a reason to fight the shorts and buy Royal Bank of Canada or Starbucks. I want to find the stocks on the list that are washed out, and things probably cannot get any worse without bankruptcy of liquidation. I give particular attention to this where the insiders are defying the shorts and buying back stock.

Although I read the list when it comes out, I only find a few trades a year. I also use it as a tool to see what traders think of stocks I currently own. If one of my stocks has moved up and short-selling is rising, it is a sign to me that I might want to consider trimming my stake. If my stock has been falling and the shorts are covering, it may be time to consider adding to my stake. Once in a while I find a stock like CompuCredit that is bombed out and can be an option with a wildly asymmetrical risk/reward potential.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider CCRT to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!