Short squeezes can be very profitable, and with prices moving 10% to 20% in one day, the risk-to-reward ratio is tempting. However, picking stocks that are ripe for a short squeeze is hard and risky. Indeed, Foolish investors should never invest just to benefit from a squeeze.
Having said that, I personally will invest in a fundamentally solid company even if 50% of its stock is out on loan for shorting. So what are some of the most hated companies on the market right now, and do they offer potential for long-term profit?
A hated refiner
First up is Western Refining, Inc. (NYSE:WNR). With 44% of its total float on short, it seems as if the market really dislikes this company. Unfortunately, the first thing I notice is that the company’s president recently sold 500,000 shares at an aggregate price of $30.70 for a total consideration of $15.4 million. Still, moving on.
Western Refining, Inc. (NYSE:WNR) owns two refiners and 200 retail stations in the south of the country. The key risks here are the company’s dependence on one refinery that accounts for 85% of production and its dependence on light sweet crude. I believe this is the reason for the market’s strong dislike of the company. The dependence on what is effectively WTI means that the company cannot switch to heavier and cheaper oil from Canada and other regions that have become popular among refineries over the past year as the Brent-WTI differential has collapsed. Heavier crudes from Canada are usually priced at a discount to WTI, so there is more opportunity for profit.
Apart from that, there is little to suggest that Western Refining, Inc. (NYSE:WNR) deserves the market’s lack of faith in it. Since the company’s near-fatal purchase of Giant Industries in 2007, net debt has more than halved (the majority of this happened since 2011), shareholder equity has doubled, and the company has $250 million in cash on its balance sheet. In addition, during the past year alone, the company has been working hard to restructure debt, reducing cash interest expense by approximately 70% — more than $90 million annually. Western Refining, Inc. (NYSE:WNR) also increased its dividend by 50% recently and started buying back stock.
So overall, apart from the declining Brent-WTI spread, I see no particular reason to disregard Western Refining, Inc. (NYSE:WNR).
Short-order cooking
Next up, with 39% of its float short, is Arcos Dorados Holding Inc (NYSE:ARCO). Arcos owns and operates McDonald’s franchises in South and Latin America. The company is hated because of the political instability rising across the region. Couple this with deteriorating exchange rates, and Arcos Dorados Holding Inc (NYSE:ARCO) rapidly starts to look unattractive.
Having said that, unless that region of the world falls into total anarchy, Arcos Dorados Holding Inc (NYSE:ARCO) still has plenty going for it. Protesters still need to eat, and the best dining option for the on-the-march protester is naturally McDonald’s (I kid — I am in no way basing my analysis on this).
Based on second-quarter results, Arcos Dorados Holding Inc (NYSE:ARCO) looks attractive in the long term and ugly in the short term. Firstly, excluding the negative effect of currency devaluation, adjusted EBITDA expanded 18.2% year on year. However, including the effect of currency devaluation, growth was nil. Adjusted revenue expanded 16.9%, and sales notched double-digit growth thanks to aggressive marketing tactics. Indeed, management noted, “The achievement of double-digit comparable sales and organic revenue growth, despite low consumer activity in Brazil and continued economic weakness in Venezuela, underscores our brand strength.”
So, all in all, the company looks attractive. The ability to grow sales while economic activity is so disrupted is not the mark of a failing company. It would appear that the high short interest owes to short-term beliefs that instability in South America will slow sales, but that doesn’t seem to be the case. The long-term investment thesis for Arcos Dorados Holding Inc (NYSE:ARCO) remains intact.
An overbought housing-recovery play
Still, analysts remain positive, estimating that Radian Group Inc (NYSE:RDN) will return to profit during 2014, generating EPS of $1, which puts the company on a forward earnings multiple of 13.7, although this is expensive compared to peer Genworth Financial, which trades at a forward earnings multiple of 8.8 but has a more diversified business model and is still cash-generative.
All in all, I would be wary of Radian Group Inc (NYSE:RDN). They say the trend is your friend, so I think the company’s stock price will go higher, but the company is still struggling fundamentally, and I would not invest in it for the long term just yet.
Foolish summary
Shorts all have their reasons for holding large positions in these companies, but these stocks’ longer-term investment theses remain intact, and for that reason I would have no problem with taking a position.
The article Do the Shorts Have It Wrong? originally appeared on Fool.com is written by Rupert Hargreaves.
Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of Arcos Dorados and WNR.
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