Shorted stocks typically suffer from one or more significant concerns about the company's business prospects.
Short sellers borrow stock and sell it at the current price, but are obligated to replace the shares they borrowed at some point in the future. If the stock falls, they profit.
But if the stock rises, and particularly if it rises quickly, the shorts stand to lose.
That sets up a short squeeze, with investors who are short scrambling to "cover" their positions and minimize losses before the stock goes any higher.
Of course, if a stock is heavily shorted, the rush to buy drives or "squeezes" the price even higher.
Investors who see a silver lining in a beaten down, shorted stock will buy in and wait for some good news to start pushing the price up, spooking the shorts into action.
Of course, that good news may never come.
That's why investors who want to use the short squeeze stock play must choose their targets carefully.
Here are Money Morning's five favorite short squeeze stock plays right now:
Short Squeeze Stock Plays: CJES, GME, SODA, ZAGG, DMNDC&J Energy Services (NYSE: CJES): This company provides hydraulic fracturing services to the oil and natural gas industries. Such "fracking" methods are required to extract oil and gas reserves from shale deposits - a rapidly growing industry in the United States and Canada. C&J has fallen to the $17.50 range from a 52-week high of $32.94 because of concerns over the falling price of natural gas. It is very heavily shorted, with 83.4% of publicly traded shares -- the float - sold short. It has a cover ratio - days at the average trading volume it would take to cover all the short positions - of 6.36.
Why the shorts are wrong about CJES: C&J reported great earnings in February, with revenue rising 156%. Net income increased more than threefold, and operating margins improved to 35.87%. All of the company's fracking equipment is deployed. CJES has zero debt. It has a remarkably low PEG (Price/Earnings to Growth) ratio of 0.29 and a P/E of just 5.73. Add in a one-year price target of $27, and C&J Energy is a pretty solid bet even without the possibility of a short squeeze.
GameStop Corp. (NYSE: GME): GameStop is a retailer that specializes in selling new and used video games, primarily those played on devices like the PlayStation, Wii and Xbox. The worry is that the GME model is eroding as more games are purchased in digital rather than physical form, a particular threat to GameStop's used-games business. Sales declined 3% in the December quarter. That has led to GME having nearly 45% of its float short, with a cover ratio of 15.55.
Why the shorts are wrong about GME: Unlike some companies that fail to react to threats to their business model until it's too late, GameStop has already made moves to adjust to changes in retail gaming. Its PowerUp customer loyalty program has attracted 17 million members in less than two years. The program tracks and uses customer buying habits both for rewards and to promote new sales. The PowerUp initiative has also helped boost GME's digital sales 57% last year. GameStop expects digital sales to triple by 2014. Furthermore, Nintendo plans to release a new version of the Wii in time for the holidays, which should push game sales higher. GameStop has no debt and a P/E of just below 9. Trading at about $21.50, GSE has a target price of $30.
SodaStream International Limited (NASDAQ: SODA): This Israel-based company makes a machine that allows customers to make their own soda at home. The profit come mostly from the sale of the consumables used in the machines, the classic "razor-and-blade" model. The stock has plunged from over $70 last summer to its current $33 range on concerns that making soda at home is a passing fad and that the business has low barriers to entry. Also not helping is the somewhat elevated P/E of 24.67. So SODA has a float short of 69.41% and a cover ratio of 7.
Why the shorts are wrong about SODA: SodaStream has beat earnings estimates five straight quarters. It sells its products in 42 countries, and has plans for major expansion in Asia, South America, and most importantly, the United States. Analysts expect revenue growth of 27% this year and 19% next year, with earnings growing even faster - 44% for 2012. And opinion is downright bullish; the mean recommendation on SODA is 1.6 (midway between "Buy" and "Strong Buy"). SodaStream has $75 million in cash against just $4 million in debt. The one-year price target is $47.35.
Zagg Inc. (NASDAQ: ZAGG): Zagg is the No. 1 mobile device accessory provider in the U.S. It sells the protective coverings and other add-ons almost everyone buys for their new iPad, iPhone or Android device. Some doubt Zagg based on possible future competition, too few distribution channels, and a past lack of transparency on the part of management. The float short on ZAGG is 45.72%, with a cover ratio of 7.89.
Why the shorts are wrong about ZAGG: In the December quarter Zagg reported revenue growth of 131% year-over-year and earnings growth of 192%. The explosion in the number of mobile computing devices should continue to create plenty of new Zagg customers. Revenue in 2012 is expected to grow 41%, with earnings growing 38%. Like SODA, analysts are sweet on ZAGG -- the mean recommendation is 1.7. Zagg trades at about $11 a share and has a target price of $21.
Diamond Foods, Inc. (NYSE: DMND): You know Diamond Foods from such products as Emerald snack nuts and Pop Secret popcorn. DMND has been absolutely hammered over the past six months, sinking from a peak of more than $90 last September to its current neighborhood around $21. In that time Diamond has been hit with an accounting scandal that cost the CEO and CFO their jobs. Diamond has had to delay its most recent earnings statement, which could violate some of its debt agreements. And DMND recently suspended its dividend payment as it tries to sort out its debt-laden balance sheet. It's no surprise the float short is 59.7% and the short ratio is 4.77.
Why the shorts are wrong about DMND: In recent weeks the company retained Dean Bradley Osborne Partners as a financial advisor to help it fix its balance sheet. The suspended dividend was part of a deal to give Diamond access to credit so it can keep up on its debt payments at least through June. That should give the company time to get its fiscal house in order, analysts say. That's key, because in terms of sales, Diamond is doing well. It reported sales of Emerald snack nuts grew 29% in the 12 weeks ended Feb. 12, while sales of its Pop Secret and Kettle potato chip lines grew faster than the overall market. DMND's PEG ratio is just 0.56. And, notably, the $43.5 target is double the current stock price. Diamond is a bit of a long shot, but if its restated earnings are better than expected, the stock could start moving up, catching the shorts by surprise. Even in a worst-case scenario, Janney Capital Markets analyst Mitchell Pinheiro estimates the brands Diamond owns would be worth $31 in a breakup.
[Editor's Note: When it comes to short squeezes, one of the biggest of all time is setting up in the silver market.
Bottom line: This sudden physical demand could squeeze silver supplies like never before... sending prices skyward.
To learn more about the best way to play the coming silver squeeze click here.]
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Tags: Short Squeeze, Short Squeeze Stock, Stock Plays