It Doesn’t Take Much to Reverse a Long-Term Shorted Stock
Up until last week, Navistar International Corp (NYSE:NAV) traded with a one-year loss of 42%. This is a stock that had seen an incredible downtrend since January 2011, and therefore had created a significant amount of short interest. Because after all, shorts want to invest in a stock that trades lower — that’s how they make money.
Last week, after announcing earnings, the stock saw gains of more than 40%. The company’s earnings were not that good; it beat on the bottom line but missed on the top line. However, the neat thing about high short interest — in this case 35.30% of its float — is that it doesn’t take a lot to create large upside. In this case it was the announcement of a new CEO. While I don’t believe in the long-term upside of this stock, investors must acknowledge that with it being so oversold that additional gains are possible.
When Shorts Cover it Often Creates a Multi-Day Rally
As a result, these results forced shorts to cover, and there were a lot of them, almost 30% of the stock’s float. As you can see with Navistar, when shorts cover it can sometimes create a multi-day rally. Therefore, watch Pandora Media Inc (NYSE:P) this week, and don’t be surprised if it continues to trade higher.
A Look at Why Some Investors Prefer Short
Two weeks ago, another stock with large short interest — 30%% of its float — saw a massive pop after earnings and has continued to trade higher. This stock is Universal Display Corporation (NASDAQ:PANL). This is a stock where the short interest makes sense, and should give retail investors an idea of what shorts might seek in a good short candidate. The stock trades at 18.13 times sales and is a maker of technologies that are used in various smartphones. And with the decline of Apple Inc. (NASDAQ:AAPL), it has also seen a decline, until it announced earnings on Feb. 28. Personally, I wouldn’t touch the stock with its valuation so high, therefore despite gains, don’t expect shorts to leave anytime soon.
Finally, one of the more controversial stocks of the last four months has also created a very large short interest. UniPixel Inc (NASDAQ:UNXL) was a small $70 million company back in December, but is now valued at over $260 million. This large run-up has followed the company’s announced of a “multi-million dollar” deal with an unnamed PC vendor.
Typically, when stocks see rallies such as this it creates more short interest, and shorts have rapidly acquired almost 40% of its float. UniPixel Inc (NASDAQ:UNXL) is another case that makes sense. It’s a stock that has rallied over 300% due to speculation. However, up until this point, the short interest has backfired, and as a result, many of the shorts have been forced to cover, which indirectly pushes the stock even higher. The process of understanding such outcomes can actually benefit longs in trying to profit from the pessimism of shorts, but in this case, my belief is that shorts will soon get this one right.
Conclusion
In my book, Taking Charge With Value Investing (McGraw-Hill, 2013), I discuss unmeasured fundamentals to explain how investors can use these things to make better investment decisions and to capitalize on overly pessimistic behavior. One topic is identifying the difference between a justly short stock and one that is not. For example, stocks such as UniPixel Inc (NASDAQ:UNXL) and Universal Display Corporation (NASDAQ:PANL) are appropriately shorted, as most reasonable investors understand that it is simply a domino effect that is leading to such large gains. However, in the case of stocks such as Pandora Media Inc (NYSE:P) or even Navistar International Corp (NYSE:NAV), investors’ pessimistic long-term outlooks can often be beneficial and create large gains when a catalyst presents itself.
To better explain, I’ll conclude with Spectrum Pharmaceuticals, Inc. (NASDAQ:SPPI):This is a company that has seen multiple years of growth, has three FDA approved products, 10 drugs in its pipeline, a P/E ratio of 8, yet still has a short ratio of 33.30. The presence of shorts will keep the stock volatile (100% more volatile than the market), and will keep it from appropriately appreciating to reflect fundamental performance. But as we’ve seen in the past, eventually the overly pessimistic outlooks will create large and sudden gains. The key is patience, being able to remain calm and logical despite frustration, and you will then reap the benefits when being short backfires.
Brian Nichols is long SPPI. The Motley Fool recommends Universal Display Corporation (NASDAQ:PANL). The Motley Fool owns shares of Universal Display Corporation (NASDAQ:PANL).
