Will Short Covering Mean Price Gains At 3 Growing Companies?

May 10, 2023 at 07:23 AM EDT

Stocks Short covering

Frequently, short sellers will target stocks of troubled companies, taking the quite reasonable position that those stocks are doomed for bigger losses. Meme stock AMC Entertainment Holdings Inc. (NYSE: AMC) and bankrupt retailer Bed, Bath & Beyond Inc. (NASDAQ: BBBY) offer recent examples.

But sometimes stocks of companies with solid sales and earnings growth, or expectations for growth, become the targets of short sellers.

In those cases, the shorts believe there’s trouble ahead, at least in the near term.

Sprouts Farmers Market (NASDAQ: SFM), Life Time Group Holdings Inc. (NYSE: LTH) and Super Micro Computer Inc. (NASDAQ: SMCI) have all been in the sights of short sellers, but all three have some positive aspects that could mean the shorts are wrong.

Short sellers do indeed make mistakes, and often.

Short covering is when investors borrow shares to sell, on the belief that the price will fall, and are forced to buy the same stock to close their position when the price rises. That limits their losses, but it can create additional buying pressure on the stock, causing the price to rise even further.

Forcing Short Sellers' Hand

A big move up, especially a breakaway gap, forces a short seller’s hand. You can see this happening after a better-than-expected earnings report, for example. On the Life Time Group Holdings chart, using a bar or candlestick view, you can see a heavy-volume gap up on April 25, following the first-quarter report.

A huge spike in trading volume is generally due to institutions, whose algorithms kick in when a certain price or earnings threshold is met. Human traders at the big institutions also hit the “buy” button when that occurs. But short-covering accounts for some of the trading volume.

Sprouts, Life Time and Super Micro Computer all have a high percentage of short interest, relative to the shares in float.

Sprouts Farmer’s Market

The natural grocery chain has a ratio of 16.3% short interest as a percentage of float. Anything about 15% suggests that shorts could give the stock a temporary boost in demand.

What’s interesting here is that Sprouts has been growing earnings at double-digit rates. Sales growth bounced back last year, after declining in 2021. The company’s first-quarter report beat top-and bottom-line views, as you can see using Sprouts Farmer’s Market earnings data.

The stock gapped up 8.11% in four times the average volume following its earnings report. It’s since pulled back, for reasons that likely include profit-taking, as well as a respite from short-covering. Wall Street expects Sprouts to grow earnings by 11% this year and another 3% next year, and short-covering may continue to provide some nutrients for an uptick.

Life Time Group Holdings

The operator of fitness clubs is getting into shape. The company, which went public in 2021, slimmed down its loss last year, and is expected to muscle its way to profitability this year.

The stock has 19.2% short interest relative to float. It’s understandable why some investors and traders would take a bearish view, given the history of losses. But that’s not unusual in a newly public company.

Concern about the company’s debt may be fueling short-selling, but things are changing. On May 2, the company said S&P upgraded its debt to B from B-. That’s still speculative, in what’s commonly called the “junk,” or more formally, “high yield” category.

In the announcement, Life Time said, “As reasons for the upgrade, S&P Global cited improving performance, including membership, revenue and EBITDA trends, and steps the company is taking to continue to improve its balance sheet and reduce leverage.”

On May 9, Life Time said it refinanced $274 million in debt, extending the maturity and increasing the facility to $310 million as a result of strong demand.

Wall Street expects the company to earn $0.33 a share this year, and $0.52 a share in 2024. Revenue has grown at double-digit rates this year. This could be another case of short-covering causing more spikes in the stock’s price, over time.

Super Micro Computer

Shares of Super Micro Computer surged 28.27% on May 3 after the maker of storage and server gear issued better-than-expected guidance for the current quarter, largely due to its customers moving toward AI applications.

Short interest in the stock represents 13.2% of shares in float.

In this case, it seems the short sellers underestimated the company’s potential, following reduced expectations for the most recent quarter.

Much of the May 3 price increase was due to institutional buying; trading volume grew by 382%. That can’t be all short-covering, but that high short-interest number indicates that plenty of naysayers were taken by surprise.

Super Micro Computer was added to the S&P 400 mid-cap index in December; year-to-date, it’s outperformed that benchmark by a huge margin.

After the gap-up, Super Micro Computer stock rallied to a new high of $143.53, undoubtedly squeezing some shorts on the way up. The Super Micro Computer chart shows that It’s since pulled back slightly, but is trading well above short- and medium-term moving averages. More short-covering may yet result in another move higher.

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Will Short Covering Mean Price Gains At 3 Growing Companies?

Forcing Short Sellers' Hand

Sprouts Farmer’s Market

Life Time Group Holdings

Super Micro Computer

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