When Insiders and Short-Sellers Collide

 | Feb 01, 2012 | 4:20 PM EST
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Yesterday I was chatting, as I do most days, with some fellow Real Money contributors about stocks, sports, politics and a wide range of other topics. Yesterday, Bob Lang mentioned a stock he was trading as an earnings play. The stock was a momentum favorite that also had a large short interest. Bob was buying a straddle as earnings approached, and as he said, he didn't care who got crushed, shorts or bulls, as long as someone did.

I will leave it to Bob to reveal the stock, but his statement made my memory pop into action. I used to use a screen of stocks with insider buying and a high short interest to find potential turnarounds that could explode higher on good news. It was very successful and helped find some ideas that had extraordinary three-to-six-month price moves. When I combine this screen with my basic valuation work, it often shines a light on value stocks that are improving their fundamentals and are ready to reverse course and move higher as shorts are forced to cover.

I decided run a screen to look for stocks with high short ratios and recent insider buying to see if there were any candidates worth further exploration. Before I go into my findings, I have to give a shout-out to fellow contributor Jonathan Moreland. The screen on his Insider Insights website is on the best I have used and is now in my daily arsenal of tools.

I was pleased to see that some my favorite smaller regional banks were on the list. Renasant (RNST) is a bank I have owned for some time now. The bank is trading above tangible book value by a few dollars right now, so I wouldn't mind seeing the shorts win in the short run to bring the price back down. In its latest reports, nonperforming loans were just 1.56% of total loans, and the loan-loss reserve was 127% of nonperformers. The tangible-equity-to-assets ratio is 7.3, so it has adequate capital. Short interest in the stock is 6% of the float, and the short interest ratio is a healthy 26. Insiders, including the president of the bank, have been buyers of the stock in recent weeks.

I am also seeing a battle brewing between insiders and short-sellers in the hotel sector. Morgan Hotel Group (MHGC) owns boutique hotels in major cities in the U.S. as well as locations in the Caribbean and Mexico. In November, Morgan Hotel sold its two London hotels to investors, but it will continue to manage the properties. It used some of the proceeds to buy Light Group, an operator of restaurants and nightclubs with some locations in premier Las Vegas hotels. More than 10% of the float is sold short, and the short ratio is 22. Insiders, including Ron Burkle the billionaire investor, have been consistent buyers of the stock in the last year. I like the hotel business here, and if good news forces the shorts to cover, the share price could easily move back into the double digits over the next year.

One of the more intriguing companies on the list is Rosetta Stone (RST). Every time I pass the company's mall kiosks, I am intrigued by the idea of learning a new language but put off by the fairly stiff price of the program. Apparently, I am not the only one, as sales bookings to U.S. consumers dropped 14% in the third quarter, and a large contract with the U.S. Army was not renewed. The company is seeing some sales strength to institutions outside the U.S., but in general, it has struggled and is still losing money.

The stock is getting cheap enough to be interesting. The company has more than $5 a share in cash and no long-term debt. Insiders seem to feel that Rosetta Stone will be able to turn it around, as several officers, including the CFO, have been buying shares. Others are more skeptical, as 22% of the float is sold short, and the short ratio is 26. Any good news from the company could provide a pop in the stocks as the shorts cover their positions.

This is an interesting way to look at stocks. It gives you the opportunity to ask what the insiders see that the short-sellers do not. Or, of course, the shorts could be aware of a major flaw that management is not taking seriously enough. The screen can provide some actionable ideas, but its real value is in the accompanying thought process of considering both sides of the equation.

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