Is Now the Perfect Time to Short Stocks: HomeAway Inc (AWAY), Hewlett-Packard Company (HPQ)

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, Inc. (NASDAQ: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 maturityand, 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.