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Is Now the Perfect Time to Short Stocks?

David Sterman

In the late 1990s, a furious bull market led to a great deal of pain among professional short sellers. In fact, several high-profile investment firms that actively focused on short selling were forced to close as clients demanded their money back because of considerable trading losses.

Ever since, short sellers have learned to get out of the way of a rising market and reflexively draw down their positions whenever the market is rallying sharply higher. And that's just what's happening right now.

In a recent article, Bloomberg News noted that less than 6% of shares are currently held in short accounts, which is the lowest level since 2007 and roughly half the level seen in 2008 and 2009. Perversely, as these short sellers have sought to close out their bearish positions, they've added buying fuel to this market, creating deeper pain for the remaining short sellers who chose to stay engaged.

Yet this massive unwinding of short positions, known as a "short squeeze," creates an unusual opening for investors. If short sellers thought that certain stocks were overvalued to begin with, these stocks may be even more overvalued than before as short covering gave them an artificial boost. And assuming the short thesis is still intact, these stocks are likely ripe for a fresh short position now that the massive short covering trend has started to fade. (In the past three reporting periods, total short interest in the market has finally stabilized, indicating that the massive short covering phase is over.)

Here are two heavily shorted stocks that have been "squeezed" higher in this bull market but still possess considerable potential downside.

1. HomeAway.com (AWAY)
This operator of websites catering to home-based lodging completed an IPO in the summer of 2011 and initially traded above $40. However, by late 2012, investors grew concerned that annual sales growth would slow from above 30% (as had been the case every year from 2007 through 2011) to less than half that rate. Indeed, sales growth cooled to about 20% in 2012, where it is likely to remain in 2013 and 2014 as well (according to consensus forecasts) and Goldman Sachs projects it will be at less than 15% by 2015. In effect, this is an impressive business model that may be moving closer to market saturation.

If that's the case, gauging this company's level of profitability becomes crucial as it approaches maturity and, by that score, shares are starting to look quite frothy. Goldman Sachs expects HomeAway to generate $134 million in EBITDA by 2015, yet the company now sports an enterprise value of about $2.5 billion. That means shares trade at nearly 19 times projected 2015 EBITDA, which is quite rich for a company on the cusp of slowing growth. (As an alternative take, Morgan Stanley is more bullish on this business model and expects EBITDA to hit $154 million by 2015, which still yields a hefty 16 times EBITDA [to enterprise value] multiple.)

Meanwhile, short sellers have been abandoning their positions, as the short interest levels have dropped by roughly 30% during the past three months. And that has fueled this stock's impressive upward move, which as noted, has now left valuations quite frothy.

2. Hewlett-Packard (HPQ)
It's no secret that this hardware and software titan has lost its way in recent years. The company pulled off a series of growth-inducing acquisitions during the past five years, though fiscal (October) 2012 revenue of $120 billion was just 2% higher than fiscal 2008 revenue. On an organic basis, this company's top line is shrinking. Of much greater concern is the steady fall in free cash flow, which is never a good sign for a company with nearly $30 billion in long-term debt.

Hewlett-Packard's Shrinking Free Cash Flow

The fact that analysts expect HP's revenue base to shrink further in coming years means more pressure on free cash flow.

Still, shares have doubled in value since mid-November (adding a hefty $22 billion in market value) on hopes that free cash flow trends can reverse course. Although the company formally anticipated free cash flow to fall to just $5 billion this year, Morgan Stanley thinks the figure will rebound to $6.7 billion. But here's the problem with that analysis: $800 million of that amount will come from a one-time reduction in working capital, while another $500 million will come from major cut to capital spending, which is hardly the right move for a company in need of long-term growth.
Still, short sellers can't fight a bullish tape, and in the two weeks ended March 15, they covered roughly 6 million shares that were held short. For investors looking for fresh short-selling ideas, HP's rally has counter-intuitively set up the next short sale trade opening.

Risks to Consider: If the market keeps rising, the short covering may continue, helping these stocks to move still higher.

Action to Take --> Although HomeAway and Hewlett-Packard have been clear beneficiaries of the massive wave of short covering, many other stocks have as well. That makes this a good time to keep an eye on short interest levels in any stocks that have made a strong upward move in 2013 and short them if you think they're headed for a correction.

The most recent short interest data were released on March 28 (covering the period ended March 15), and new data are released in the middle and end of every month. You can find this data at the Wall Street Journal, as well as the New York Stock Exchange and Nasdaq.com.

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