Some investors look to stick to relative sure things. Warren Buffett, after all, is perhaps the most legendary of American investors at this point, and he made his fortune largely through a series of level-headed, safe investments that offered slow and steady returns over the long run. It’s tried, tested, and true. Find a good stock and prepare to sit on it for the better part of a century.
But playing it safe isn’t for everyone. Some of us love to roll the dice. And, you know what, if you can afford to take a loss if it doesn’t work out, and you know how to identify the right gambles to take, why not? If you’re willing to ride out the volatility, taking enough of the right big chances can ultimately mean much bigger returns than are possible without taking big risks.
And one way to identify potential moon shots worth rolling the dice? Looking out for potential short squeeze candidates prior to their earnings report.
Improving Your Short Game
The precise nature of taking a short position and the short squeeze are a little complicated, so if you’re unfamiliar with them you can read this article that explains them in more detail.
All you need to know here is that someone with a short position (i.e. a bet that a stock is going to fall), is incredibly exposed when that bet goes wrong. If it starts to look like a stock is going to make a big gain, the shorts have to rush to buy shares to prevent massive losses, creating a snowball effect that can cause a stock’s price to shoot up. More importantly, anyone holding a stock as it goes into a short squeeze is going to see major returns in rapid order.
How to Play Earnings Season
A short squeeze needs an inciting incident that’s going to cause the first jump in share price that will spook the shorts and cause them to start buying up shares. In most cases, predicting precisely what that might be is impossible. However, a company’s quarterly earnings report does provide a set date for an event that can cause an abrupt swing up or down in a stock, depending on whether the report exceeds or falls short of expectations.
So, if a company provides an earnings beat, the ensuing jump could very well be just the catalyst necessary to touch off a short squeeze.
It should be noted that the downside risk of investing in companies with large short floats immediately prior to their earnings reports is considerable. A company doesn’t build a large short float without some serious question marks out there to convince people ready to bet against it. An earnings miss will likely mean a decline in share price on a similar level to the pop you might get if an earnings beat touches off a short squeeze.
That said, any investor looking for a gamble, or maybe anticipating a better report than expected for a company that has attracted a lot of naysayers, could ultimately conclude that the chance at some huge short-term returns makes taking the chance worthwhile.
Last week cleared out a lot of the big name companies with eagerly anticipated earnings reports. However, there are definitely a few candidates for potential short squeezes left in the small-cap space. The four companies listed here haven’t reported Q2 earnings yet, have a short float of at least 25%, and have made gains in the last month – something that may have shorts nervous already as they head into the earnings report.
ITT Educational Services (ESI)
Market Cap: $118.56 million
Short Float: 49.67%
July Performance: +28.21%
Date of Earnings Report: July 30 (Thursday), before opening bell
For-profit education is an industry that has gone through a real whipsaw moment in the last decade or so. It grew rapidly based on the availability of federal student loan money. Then the government decided that these schools should have to prove that they’re actually providing some sort of value in their education before they can keep receiving federally-backed student loans. Thanks, Obama!
In ITT, you have a company that’s clearly suffering through market conditions that have battered its industry, but is also starting to look like one of the last companies standing after the worst is over. Certainly, shorting ITT has been a pretty solid investment virtually any time since it peaked at just under $130 a share in 2009.
For starters, the company increased profits and operating margin in 2014 after both had shown steady declines since 2010. The company also appears to have leveled off a trend of declining revenues over the last five quarters. Finally, the stock’s shown some real rebound in its share price in July, gaining nearly 30% and likely making any remaining shorts skittish about their position. Add to that the fact that the share price has recently broken through a declining resistance level that can be traced to last October and the possibility for a pop in the near future is distinct.
If ITT’s Thursday earnings report – set to be released prior to the opening bell – beats analyst expectations, there’s a chance that the remaining shorts will take it as a sign to get out of this game for good.
TCP International Holdings ($TCPI)
Market Cap: $128.59 million
Short Float: 42.88%
July Performance: +10.3%
Date of Earnings Report: August 6 (Thursday) after closing bell
TCP is a Swiss technology company specializing in energy-efficient LED displays. The company has shed about a quarter of the value it had at the start of the year, with most of that decline coming during an early March freefall touched off by a lawsuit from a former employee. The lawsuit, brought by the company’s former General Counsel Laura Hauser, includes claims that she was verbally abused and physically assaulted by CEO Ellis Yan and that the company shipped some 40,000 bulbs bearing a “UL” mark that shouldn’t have.
The company did show a weak Q1 for revenue, but it is still in the midst of a lengthy uptrend, with major revenue gains each year since 2011. If the company bounces back from Q1 to show solid sales, it’s not hard to imagine continued gains that could frighten off shorts who thought they saw blood in the water with Hauser’s lawsuit.
Market Cap: $1.53 billion
Short Float: 38.45%
July Performance: +7.54%
Date of Earnings Report: July 30 (Thursday) after the closing bell
Outerwall is the parent company for specialty retail services like The Redbox, Coinstar, and New Ventures. At first blush, it’s unclear why Outerwall has so much short interest. For starters, there aren’t a lot of periods in the company’s history where a short position would have worked out. The stock’s up this month, it’s up a little more than that year-to-date, it’s gained more than 50% in the last year, and almost 75% in the last five. Add to that a P/E ratio under 12.5 and a P/S ratio of 0.65 and this is a stock that seems solid.
The concern would be in the company’s receding growth. From 2010-2013, the company showed steady increases in revenue, net income, and profit margin. Last year saw those numbers plateau, though, and then start to recede. With the “what have you done for me lately” mindset common throughout Wall Street, then, it’s not hard to see the logic. Outerwall is connected to brick-and-mortar retailers, an industry that’s on the decline. Contracting revenue is just the sign of what’s to come.
That said, if Outerwall can indicate that it’s broken and/or reversed that trend, it starts looking like a pretty solid value buy with a decent dividend and a history of growth. This is a stock that’s been showing steady returns for a long time, so it’s not hard to imagine a post-earnings bounce rattling the resolve of any shorts out there.
Market Cap: $578.73 million
Short Float: 26.45%
July Performance: +4.27%
Date of Earnings Report: August 5 (Wednesday) after the closing bell
Workiva is a cloud-based service that helps businesses collect and organize data in real time. The company only went public in mid-December, so it’s currently very young. Workiva appears to be showing a familiar narrative: a budding tech company that’s rapidly growing its revenues but is also growing its losses in the process. Can Workiva pull its margins together and start creating real profits? Or is this another company that still hasn’t figured out how to monetize its activities well enough to warrant its valuation?
Only time will tell. It also means that Workiva is likely extremely sensitive to the perception investors can take from its earnings reports. The company’s last three quarterly reports showed improving margins and declining losses; if it can hit one out of the park for Q2, it might drive out the last of the shorts. The company’s been up and down all year, but has ultimately showed a gain of over 7.5% year-to-date.
Attempting a Short Squeeze can Lead to a Severe Portfolio Squeeze
Trying to anticipate a short squeeze by buying into a heavily shorted company prior to its earnings report represents a really risky strategy. As noted above, a big earnings miss will likely translate into pretty heavy losses. And it should be noted that the companies we highlighted were selected based on their recent stock performance and the size of their short float, not any specific reason why their upcoming Q2 report might be a major beat.
However, the potential for the cascading gains generated by a short squeeze could be just what investors with a healthy appetite for risk are looking for. This is particularly true if you’re familiar enough with the company and/or industry to have real, concrete reasons to anticipate an earnings beat.
If that’s the case, happy gambling, folks!
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