The short squeeze is a stock market occurrence that is not truly appreciated given the effect it can have on a stock price in a given time. For those unaware, a short squeeze occurs when a stock that has been heavily shorted is covered by the short sellers.
When someone shorts a stock, they are betting on a stock price decline. When someone goes short a stock, they are borrowing the shares and agreeing to return those borrowed shares at a future date, thus effectively committing themselves to buying those borrowed shares in order to return them. The buying back of those shorted shares creates additional demand, which causes the price to increase. Other short sellers, not wanting to buy back at a high price, also start to cover their short positions. The stock climbs further. At that point, a short squeeze begins to occur, where many short sellers at once rush in to buy. The result is a surge in the stock price.
To really understand where a short squeeze can create value, one has to look at the underlying business. Typically when investors go short, they do so with businesses with no future prospects or, in some cases, where they see fraud or other instances of corporate malfeasance. In other cases, traders go short simply because Mr. Market is pessimistic on the current short-term prospects of a business; these are the opportunities to seize on a short squeeze.
Two companies that fit this latter bill come to mind: Chesapeake Energy (CHK) and Sears Holdings (SHLD). Both of these companies, in my view, have huge upside potential in the coming years. And both are heavily shorted. At present, 14% of Chesapeake's shares and 25% of Sears' shares are shorted.
Each and every quarter, CHK's balance sheet is getting better and the company is becoming very efficient. It's simply a matter of time before those operational improvements show up in the stock, and when they do, there will be a rush to cover millions of shares that have been sold short.
Sears Holdings is an even more extreme case. Viewed as a traditional retailer that has been losing money for years, the company has all but been abandoned by investors. Two investors -- Chairman Eddie Lampert and fund manager Bruce Berkowitz -- own more than 75% of the company. Of the remaining 25%, the vast majority is held by short sellers who thus far have been rewarded very well. But the reality is that Sears is moving away from the traditional retail model and Lampert is a brilliant capital allocator and puts shareholders first.
It's a matter of when, not if, the shorts cover. And when they do, these shares should appreciate significantly from today's historically low prices.
