Every (amateur) investor’s dream is to get rich quickly. After a few years in the markets, more experienced investors know this is a naive attitude, most often only good enough to lose money quickly, i.e. the opposite of what was intended initially. However, a suitable strategy which can be mixed into a stock portfolio – especially when searching for uncorrelated ideas – is to look for potential short squeeze targets, given the underlying businesses are not one step away from bankruptcy. A look back at some prominent short squeezes. My members on top receive my latest research report with a potential short squeeze candidate.

Summary and key takeaways from today’s Weekly
– Short selling requires extensive due diligence as well as very strong theses.
– Most stocks likely are shorted for a reason or two as the underlying companies either have operational difficulties or in the extreme can be fraudulent.
– Sometimes it happens that too many stocks are shorted, leading to explosive moves to the upside.

Before we get started, a few words about short selling.

Generally, I am a firm believer that short sellers are not mainly evil, greedy market manipulators by profession, but that their existence is even necessary.

Unfortunately, the common narrative is that manipulations mainly occur to the downside, but mysteriously never or very rarely to the upside. Enron anyone? Or the strange case of AI-bubble poster-child growth-wonder Super Micro Computer (ISIN: US86800U1043, Ticker: SMCI) that isn’t able to file it’s 10–K (see here and here) even on the prolonged deadline?

Likewise, I don’t buy the garbage that short sellers are responsible for big stock market crashes. Has at least once someone been found?

Exceptions apply, but this is how I am seeing it. Why?

As with short selling one theoretically can suffer an infinite loss on their investment (as stocks can, again theoretically, only fall by 100% but multiply several times), their preceding due diligence has to be very profound. While someone can buy a stock without even any half-way firm thesis at all and nonetheless have a lucky shot during a bubble, short sellers face limited upside, but unlimited downside pressure.

If they’re right, though, they can make quick profits which on an annualized basis are substantial.

Often, shorted stocks are in this position for a reason or two. Expectations are that the stock will decline or continue to do so. In essence, one could say that short selling serves as a cleaning mechanism to filter out and separate the garbage, especially when we are talking about fraud or inflated numbers.

But that’s not the topic of today, as we’re discussing the other side of things, namely short squeezes – heavily shorted stocks that stop falling and instead suddenly start to explode to the upside.

From time to time, there are cases where the boat simply gets to full.

Too many shares are sold short and due to an unexpected or at least thesis-changing external catalyst, buying pressure starts to build up.

New buyers come in and / or first short sellers start to close their positions (they need to buy back the previously sold shares), sending stocks at times even dramatically higher by several factors, when there’s suddenly an under-supplied situation with too much demand buying whatever is available, no matter the price.

There have been some noteworthy short squeezes in the past we are going to look at in today’s weekly. My members in parallel receive my latest research report with a potential short squeeze idea – a company which has several potential catalysts, ready to cause a chain-reaction to the upside.

As energy prices and especially oil have come down massively, my picks have suffered a setback, as several of my ideas come from this sector. That’s why on average my ideas are currently trailing the benchmarks.

However, my ideas have done great in their respective peer groups, holding up comparatively well, avoiding a huge slaughter.

Other ideas, like my gold mining pick, are doing very well, while other ideas are waiting for their individual catalyst to come to fruition.

All in all, I feel much safer than would be the case owning mainstream names, especially tech stocks.

Join me and my members on our journey to beat the markets!

^{both as per 18 September 2024 market close – since August 2022}

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When shorties lose their pants

Certainly one or the other of my readers will instantly know that this headline is referred to Elon Musk once having sent hedge fund manager David Einhorn of Greenlight Capital a box of shorts after the latter’s failed attempt to short the stock of Tesla (ISIN: US88160R1014, Ticker: TSLA).

Jokes aside, while potential gains can be made quickly in the case of a crashing stock, the other part of the truth is short sellers can burn their fingers in a very painful way.

It’s no secret that short sellers lost billions on trying to bring down Tesla.

The ideal outcome for a short seller is to see the (borrowed and) sold position to fall quickly so that it can be bought back at a way lower price.

The faster, the better, not just from a psychological point of view.

“Quickly” is the key here, as shorting stocks is not only not without risks, but it is also not for free, as short sellers need to pay a lending fee to their broker and if applicable also the dividend to the owner of the equity from whom it was borrowed.

The bottom line is, while going long (buying and holding a stock) does not face time pressure as time is the friend of the patient investor, assuming the case is solid, short sellers don’t have an infinite amount of time.

It can even be the case that their cost to short-sell a stock is higher than 10%, even 15% per annum when they face a high-yielding dividend stock and high borrowing costs. That’s why I think now with high borrowing costs it could be worth it to look for heavily shorted, but operationally stable enough, companies.

Should the market not be doing the favor and the stock doesn’t fall, sooner or later the position will need to be covered, i.e. bought back.

Sometimes a stock simply stops falling.

But there are also cases, when an external catalyst ignites a big fire, causing ripple-effects. These are those events where brutal explosions to the upside occur as the majority gets caught by surprise. New first-time buyers and short sellers with the intention to cover their positions start to chase the available supply which can be outnumbered even several times when things turn upside down.

When suddenly everyone wants to buy, there’s only one possible direction: up!

Thinking about examples, four of them instantly came to my mind.

Likely the most prominent recent case is GameStop (ISIN: US36467W1099, Ticker: GME), a struggling legacy gaming software and accessories retailer. Some time ago, I had a look at the stock (see here).

During 2020, it seemed that the company was going out of business, sooner than later, due to quickly evaporating sales, negative operating earnings and debt on the balance sheet. Everyone was betting agains it, the stock was heavily shorted.

But then, a buying mania seemingly initiated from social media personality Roaring Kitty set in, pulling in retail investors and forcing short sellers to cover their positions on this comparatively small company.

A good source for a quick overview is Market Beat (but you need to check the data as e.g. the number of outstanding shares below isn’t correct).

Looking back at 2021, above we can see that almost 7 bn. USD of market value were sold short. What doesn’t sound like much when thinking in dimensions of big tech stocks, I am giving you a second number. GME had a market cap of less than 2.5 bn. USD until 20 January 2021, so effectively depending on how you look at it, more shares of GameStop were shorted than issued.

Even 1:1 or 100% is already quite a dramatic figure where one better should not be on the short side of things.

A crazy anomaly and certainly the most extreme case I am showing today.

In hindsight, no wonder the following happened:

We can see that the stock of GME is still up by more than 1,700% over the last five years, despite share count being up by roughly 50% and despite the continued slow-dying of the company, at least regarding its core business. Earlier this year, there was another second short squeeze, but less dramatic than the first one, so I am leaving it with that.

Management several times raised equity near the spikes, thus the balance sheet is full of cash. However, the core business continues to quickly melt away. Until now, it is completely unclear what the management intends to do with their 4 bn. USD in cash (50% of the market cap) as they don’t give conference calls and do not even comment on earnings results.

Now, the short interest ratio is somewhere between 8% (Seeking Alpha) and 10% (Market Beat). While not low, far away from the extreme levels before. As everyone knows the stock by now and the figures not being at brutal extremes, it is definitely better to stay away from the stock.

As a rule of thumb one can say that a stock with at least 10% of its equity sold short is seen as heavily shorted.

Next one, AMC Entertainment Holding (ISIN: US00165C3025, Ticker: AMC), a struggling theater chain that has been pushed against the wall by the lockdowns years before, but also by growing streaming services and a big debt load.

Similar story and similar picture.

A heavily shorted stock with a seemingly dying business and in this case a gigantic amount of debt experienced a last rush from a market cap of 5–6 bn. USD to more than 30 bn. USD, while the business was (and still is) burning cash.

Net financial debt is 3.6 bn. USD and I do not know how they want to handle that.

In the case of AMC, we had give or take also a short ratio of 100% (5 bn. USD market cap and less vs. 5 bn. USD sold short at the extreme), sending the stock up 5–6x before it crashed and resumed its decline.

Like GameStop, AMC also massively raised equity, but it only has bought them some time. Nothing more. With 14% of the stock being sold short, this doesn’t seem to be an attractive enough setup, especially as AMC has less cash and higher burn-rates than GameStop.

As above I mentioned Tesla, obviously I need to look at that case, too.

By far not that extreme like the two above, nonetheless measured by “normal” standards, 20 bn. USD short sold of Tesla stock equaled about 20% of the market cap.

This is quite significant, if you consider that Elon Musk was and is the biggest shareholder with ~20–25%, effectively shrinking the float by that amount and increasing the short ratio to around 25% – the market cap was 100 bn. USD then.

The stock didn’t surge like the two examples before, but it went up by a factor of 8x over the subsequent two years, slowly pushing shorts out (short ratio < 2.5%).

For the sake of completeness: The situation from the beginning of this weekly was from 2018 where Tesla was attacked several times, but managed to pull itself out of a tough financial situation. But I think you get the message.

Last but not least, we need to mention Volkswagen‘s common shares (ISIN: DE0007664005, Ticker: VOW) which made the company in 2008 for a brief moment the most valuable company on earth when the smaller and then-independent sports-car maker Porsche was trying to take over the bigger Goliath in the middle of the 2008 financial crisis – maybe that’s the most dramatic and famous short squeeze ever.

Actually, it started already several years earlier, when Porsche step by step bought equity of VW, which soon reached 35%. Unfortunately, Porsche used debt and unfortunately the financial crisis hit them hard.

VW to this day has two equity classes and hedge funds tried to make use of the then occurred disparity between both.

When it came out that Porsche was not only owning a big equity stake, but on top options to acquire more (for a ownership of in total ~75%, plus the state of Lower Saxony owning another 20%), the market suddenly realized that there weren’t enough shares left in circulation to cover shorted stocks.

The result was the following:

For sure, the examples above make hunger for more.

Who doesn’t want to find a quick multi-bagger?

However, the reality is it is not so easy to find such situations. In practice, companies like GameStop or AMC bring huge risks with them as their businesses are dying, at least in the current forms. Also, short squeezes do not necessarily end up as multi-baggers. More realistic expectations should be set between 50–100%.

What you also need to keep in mind is that these data like short ratios are not real-time data. They are being published twice a month only. That’s why discussing such cases in hindsight is easy, but tough to spot them before things happen. Also, when these data are released, it is entirely possible that the real-time figures have changed dramatically.

Another thing to be aware of is, most stocks likely are shorted for a reason, as their underlying businesses are not doing well or short sellers could be anticipating moves like a dividend cut which often sends stocks lower (but makes borrowing costs cheaper!).

That said, with anything below 20% sold short, maybe even 30%, I wouldn’t mess around as there is likely more noise than substance to think about a try.

On top, I do not want just to play by numbers, but furthermore there needs to be some meet to the bone, e.g. in the form of a potential catalyst and / or hidden values on the balance sheet. Why not both in combination?

This is how I came across my latest stock idea for my members. In my new research report, I am discussing the case of a company with:

• more than a third of its stock sold short – a record level
• three precedents where even coming from lower levels the stock started to surge massively
• substantial hard assets on the balance sheets which are likely much more worth than the entire company including debt currently on the market
• a double-digit dividend yield that is covered by free cash flow (but it might be cut in the future)
• an almost record-low valuation, despite the business not being on the death-bed
• the potential to restart buybacks (pressuring short sellers) as soon as next year, when the balance sheet is strengthened further

I think this is an idea worth thinking about for a potential gain of 50%+ if and when the full boat starts to tilt.

What I like about this idea is that the stock can surge dramatically any time, even despite the sector it is operating in faces challenges. And of course also not correlated to broader markets.

Conclusion

Short selling requires extensive due diligence as well as very strong theses.

Most stocks likely are shorted for a reason or two as the underlying companies either have operational difficulties or in the extreme can be fraudulent.

Sometimes it happens that too many stocks are shorted, leading to explosive moves to the upside.

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