There is nothing better than watching short sellers get burned. While short selling might have its place in the market, there is something un-American about the practice of betting against publicly traded company’s success. It’s just not our style to hope for failure, and yet plenty of short sellers are betting against stocks like Research In Motion (NASDAQ:RIMM), Netflix (NASDAQ:NFLX) and Green Mountain Coffee Roasters (NASDAQ:GMCR)
Short sellers believe these stocks are too richly priced with an expectation of smaller profits and lower revenues. And investors who short these and other stocks do so in big amounts, creating an opportunity for buyers in the event of a short squeeze.
The sheer volume of a stock sold short can be rocket fuel to the upside should the bet against failure fail. All that’s missing is the trigger.
That trigger? Earnings reports. To the extent a company that is heavily shorted reports positive news, the upside potential can be significant. It is not unusual to see heavily shorted stocks move 10% or more in one day of trading after a strong report.
Here are five heavily shorted stocks that might surprise the bears:
The airline industry has been sold heavily for most of the year, but none more so than American Airlines parent AMR Corp. (NYSE:AMR). Shares are down 64% in 2011, and helping that decline are short sellers. As of the end of September, more than 60 million shares were shorted.
The expectation is that AMR will be forced to reorganize in bankruptcy, thereby eliminating any value for common stockholders. AMR management vehemently denies that it will need protection in bankruptcy court. Despite heavy losses on an operating basis, AMR is reinvesting in its fleet by ordering new aircraft.
In the quarter being reported Wednesday, lower oil prices and an economy that still was hanging tough could push profits higher than expected. To the extent AMR can take bankruptcy off the table, shorts will run for cover. This stock could move 20% higher or more on a short squeeze.
Buffalo Wild Wings
Momentum stocks often are a target of short sellers. At some point, the music of profit growth stops. When the music stops, shares can tumble. The trick, of course, is timing. To the extent growth surpasses expectations, a short squeeze can occur.
Casual dining stock Buffalo Wild Wings (NASDAQ:BWLD) is a fast-growing business that has piqued the interest of short sellers. As of the end of September, nearly 13% of shares outstanding were sold short. Helping to cement the bear case was the company missing analyst estimates in the period ending June 30.
Prior to that miss, BWLD had exceeded estimates in the three quarters before that. With food prices lower and a consumer base that continued to spend, Buffalo Wild Wings is likely to beat expectations for the quarter ending Sept. 30. From a valuation perspective, shares are much less frothy. The stock trades for 22 times current-year estimated earnings. That also happens to be the rate Wall Street expects profits to grow in 2012. Stronger earnings could propel shares higher when the company reports results Wednesday.
The consensus of many is that the economy will slip into recession in the very near future. With negative GDP growth, many industries will suffer. Big-ticket items like automobiles will have to wait in such an environment. Car sales are likely to fall in a recession, hurting that sector.
AutoNation (NYSE:AN) is a heavily shorted stock. At the end of September, 18.5% of shares outstanding were being sold short. That is a lot of stock sold in advance of an expected decline. So far, the economy seems to be hanging tough. We might not be out of the woods, but the worst-case scenario might be off the table.
The shorting of AutoNation comes despite the company performing well on an operating basis. The company has exceeded analyst estimates in the past three quarters. Given that estimates for the current quarter have not budged during the past 90 days, another beat is possible. Wall Street is looking for the company to make 47 cents per share for the quarter ended Sept. 30.
Looking forward, Wall Street has low expectations for AutoNation. Profits are expected to grow by only 12%. AN shares are trading at a premium valuation, at 19 times earnings. That explains why there are so many shorts in this stock. It will take a strong report Thursday to shake them loose and create a short squeeze.
ITT Educational Services
The for-profit education sector has been hit hard by tighter standards for student loans, negatively impacting enrollment. Stocks in the sector are down significantly from prior highs, and short sellers have pounced, looking for further losses. ITT Educational Services (NYSE:ESI) had 9.44 million shares short at the end of September.
Shares of ITT Educational Services are down about 37% since selling in the market began in July. That seems fairly excessive considering that for-profit education should see a boost in enrollment if the economy slips into recession — when unemployment is high, those serious about getting a job get serious about improving their resume through education.
All of the selling in ITT has made ESI stock very cheap relative to expected profits. At current prices, the stock trades for just six times current-year estimated earnings and eight times next year’s estimates for profits. Whatever froth existed in this stock is no more. To the extent the company can impress Thursday, look for short sellers to run for the hills.
Life Time Fitness
If the economy does indeed recede, look for consumers to curb spending on discretionary items. Health club memberships might be vulnerable as a result. That appears to be the concern of those now selling short Life Time Fitness (NYSE:LTM). As of the end of September, 25% of Life Time’s float was held short.
The bear case makes sense, but not if earnings continue to impress. The company has matched or exceeded estimates in the past two quarters. For the period ending Sept. 30, Wall Street estimates have increased by only a penny per share. For the full year, the company is expected to report a profit of $2.31 per share, growing 16% to $2.69 per share in 2012. At current prices, LTM trades for 17.5 times current-year estimated earnings.
While it is reasonable to think health club spending will slip during a recession, Life Time should continue to benefit from more individuals adopting healthy lifestyles. The desire to extend lifespan could outweigh the potential for less spending in this space. Consumers are likely to cut elsewhere.
We will find out when the company reports results Thursday. If guidance is reaffirmed or increased, the short case could get buried, and a squeeze-powered stock rally would ensue.
As of this writing, Jamie Dlugosch did not own a position in any of the aforementioned stocks. Get a free copy of his five keys to trading earnings here.