Short Squeezing Profits

 | Jan 18, 2012 | 2:30 PM EST
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I am not a fan of shorting stocks, mainly because I'm not keen on making bets with unlimited downside and a capped upside. But, other unattractive reasons prevent me from shorting, specifically, a stock that continues to increase in price, forcing you to take the loss, only to see the stock price start falling afterward. I think short sellers like David Einhorn, who shorts for the right reasons, provides a valuable cleansing mechanism to the market.

Since I'm not as good as Einhorn when it comes to shorting, I use the trade from another angle in searching for opportunity: Seeking quality companies at decent valuations that have the added catalyst of a short squeeze. When the market's opinion of a business whose stock is heavily shorted begins to improves, the stock's upside climb gains a strong tailwind from all the short sellers looking to cover, or buy back, the borrowed shares.

However, choosing a quality company is key. Trading merely on the hope of a short squeeze is like trying to catch a falling knife while blindfolded. A decent business that is heavily shorted has some imperfections, at least in the eyes of those shorting it, but if those imperfections are surmountable, then it may be a worthwhile name to explore.

This was the case with Builders FirstSource (BLDR), a name I first suggested last November when shares traded around $1.50. As a leading supplier to homebuilders, the company had been struggling for the past few years. But, recently, it refinanced its debt and is dirt cheap on any sort of housing recovery scenario. Unsurprisingly, a few investors were short the company. Over the past few weeks as small signs of hope emerged for the housing market, suggesting that the sector's troubles may finally be over, BLDR assumed a steady advance to $2.70 a share.

ATP Oil & Gas (ATPG) is company that has quickly fallen from being a market darling to a company everyone wants to hate, with the concern being the company's $2.4 billion of net debt. Yet, the majority of that debt is high-yield bonds due in May 2015. But even if the debt becomes a serious issue, any asset sale would be more than enough to meet all credit obligations with plenty left over for equity holders. The company's proved and probable reserves are estimated to have a present value of $4.8 billion, while proved reserves have a present value of over $2.6 billion. Today, shares trade for $6.74, or a market value of $344 million and an enterprise value of $2.2 billion. More than 50% of the share float is in the hands of shorts. ATP has a successful history of monetizing assets, and such future monetization could be the spark that ignites shares and sends shorts covering.

When shares were trading for nearly $300, everyone found Netflix (NFLX) glamorous. Even folks who correctly shorted at $175 scrambled to cover as the stock climbed higher, only to watch in agony afterward as the shares plummeted. Now that Netflix shares are trading for $94, some shorts are still holding on with nearly 20% of the stock held short. Despite the company's current struggles, it still offers consumers attractively priced entertainment package. With Netflix, the company can very quickly become the growth darling it once was and shares could begin to climb back up very quickly. Any short seller is aware of this and would very likely be quick to cover the short position.

Simply betting on a short squeeze can be just as costly as going short. But if you can identify decent businesses with temporary troubles and get in at a good price, a short seller can actually turn out to be a long investor's friend.

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