Hate is a powerful emotion in the market. It's powerful because, more often than not, it's wrong.
Investors hate stocks that scare them. They hate stocks that have burned them. They basically hate any stocks that they don't already love. But what most investors don't realize is that taking a second look at Wall Street's most-hated stocks could provide some much-needed love for your portfolio in 2013.
Going back over the last decade, buying heavily shorted large and mid-cap stocks (the top two quartiles of all shortable stocks by market capitalization) would have beaten the S&P 500 by 9.28 per cent each and every year. That's some material outperformance during a decade when decent returns were very hard to come by.
It's worth noting, though, that market cap matters a lot – short sellers tend to be right about smaller names, with micro-caps delivering negative returns when the same strategy was used.
Let's replicate the most lucrative side of this strategy with a look at five big-name stocks that short sellers are piled into right now. These stocks could be prime candidates for a short squeeze in 2013.
In case you're not familiar with the term, a "short squeeze" is the buying frenzy that ensues when a heavily shorted stock starts to look attractive again to investors, causing share price to skyrocket. One of the best indicators of just how high a short-squeezed stock could go is the short interest ratio, which estimates the number of days it would take for short-sellers to cover their positions. The higher the short ratio, the higher the potential profits when the shorts get squeezed.
Naturally, these plays aren't without their blemishes – there's a reason (economic or otherwise) that these stocks are hated. But for investors looking for exposure to a speculative play with a beefier risk/reward tradeoff, these could be powerful upside plays for the coming year.
Without further ado, here's a look at our list of large-cap short squeeze opportunities.
Johnson & Johnson
It may seem surprising that blue chip giant Johnson & Johnson makes the list of most-hated stocks. The $200-billion healthcare firm is a go-to dividend name for income investors, and it's sitting on around $4-billion in net cash after all of its debt is accounted for. Even so, Johnson & Johnson currently sports a short interest ratio of 12, which means that there are so many short sellers piled into this stock that it would take more than two weeks for bears to exit this stock.
Johnson & Johnson is the biggest healthcare company in the world; it makes everything from consumer products like Band-Aid brand bandages to pharmaceuticals and medical devices. While patent loss concerns on JNJ's pharma unit contribute some to the negative sentiment in this stock, they don't account for the pile of short sellers that's currently positioned in shares. That's especially true now that the Synthes acquisition is closed, boosting JNJ's medical device business.
Financially, they don't get much better than JNJ. The firm's positive net cash position is attractive, and it's understated because of the mountain of cash that Johnson & Johnson parted with as part of the Synthes deal. In reality, JNJ's cash generation capabilities are impressive, and they should continue to fuel the firm's 3.43 per cent dividend yield for the foreseeable future. Late January earnings could be a big catalyst for a short squeeze.
Colombian oil and gas company Ecopetrol is another large-cap name that's getting hated by investors right now. The Bogota-based firm is at $120-billion is the biggest energy company in Colombia, generating around 70 per cent of the country's output. And with a 90 per cent stake held by the country's government, that market-leading position isn't likely to get ceded any time soon.
Ecopetrol is a vertically-integrated oil and gas firm, with operations ranging from exploration and production to refining and transportation. That integration helps keep EC's profitability numbers strong – and crude oil prices resting near historic highs for sustained periods don't hurt either. That said, exposure to the volatile Colombian Peso doesn't help investors' love affair with this stock, particularly given the strong performance of the U.S. dollar in recent years.
In 2007, Ecopetrol made the move from being a part of the government to being a self-run corporation whose largest shareholder just happened to be the government. While that separation has helped increase investors' willingness to buy stakes in EC, it's important for investors to remember that the powers-that-be in Bogota still have the reins of this firm. Even so, the sheer size of Ecopetrol makes maximizing profitability strategically important – and puts investors and the Colombian government on the same side. A short interest ratio of 20.2 means that it would take more than a month of buying pressure for short sellers to cover their positions at current volume levels.
Infosys has built a lucrative business providing firms in the West with outsourced IT services from its home base in Bangalore, India. Infosys was one of the first major offshoring contractors to pop up in India in the 1980s, and that first-to-market status counts for INFY's operations today. A skilled workforce of low-cost Indian programmers and consultants gives the firm pricing that competitors at home can't match alongside expertise that's not easily recreated by other Indian firms.
Infosys' bread and butter is application development and maintenance – or more specifically, helping its customers trim some of the costs associated with hiring high-salary IT programmers and developers. But in recent years, Infosys has been making other IT services a bigger chunk of its revenue pie. That, in turn, has helped to hike the firm's net margins significantly.
A couple of macro headwinds have been challenging INFY more recently, however. The firm's pursuit of premium pricing has some clients reconsidering their needs as high unemployment here at home makes "onshoring" more economically viable again. That said, the firm has plenty of time to figure out its next move – revenues continue to climb at a stair-step pace, and a debt-free balance sheet with $4-billion in cash give it plenty of wherewithal.
A short interest ratio of 15.5 makes Infosys a strong candidate for a short squeeze.
$21-billion surgical equipment firm Intuitive Surgical is having a strong year in 2012 – shares have rallied almost 16 per cent since the first trading day in January. By now, that's got to be wearing on short sellers who've been putting money on a material drop in ISRG's share price. Right now, the firm's short interest ratio of 12.2 indicates that it would take more than two weeks of buying pressure for shorts to cover at current volume levels.
Intuitive develops and sells robotic surgical systems for hospitals that want to be able to perform less-invasive surgeries than would be possible if done by a surgeon's hand. The firm's da Vinci system is currently deployed in more than 2,000 hospitals around the globe. Robotic surgery isn't just a fad – it offers patients truly significant benefits like quicker recovery times and fewer complications. As a growing number of surgeons get trained on the da Vinci system, switching costs of adopting a new platform start to get quite high, giving ISRG a sticky customer base and a big competitive advantage. The firm is also able to earn large recurring revenues by servicing machines and selling surgical instruments.
That said, it's clear that shorts are betting against the premium price tag that this stock currently sports. ISRG is unquestionably a growth stock, and metrics like its P/E ratio prove it. While value investors aren't jumping onboard ISRG right now, it's hard to argue with the sales and profit growth trajectory that this stock has been moving along for the last several years – and a debt-free balance sheet with more than $2-billion in cash and investments helps temper the loftiness of Intuitive's valuation. Upcoming earnings could be a short squeeze catalyst for this stock.
Digital Realty Trust
Technology real estate investment trust Digital Realty Trust rounds out our list. This niche REIT owns more than 100 properties around the globe, focused mainly on data centres, Internet gateways, corporate HQs and manufacturing facilities. The firm currently sports a short interest ratio of 11.1.
DLR's niche real estate portfolio is the biggest reason behind this stock's attractiveness. Demand for internet data centres and gateways is growing fast thanks to data-driven services (like cloud storage), boosting DLR's market for tenants. As long as firms need more virtual space to store data, they'll also need more physical space to store servers; that's space that DLR is uniquely qualified to provide. Because tenants' properties are effectively built to suit their specific technical needs, switching costs are very high, and DLR's renewal rates are stellar.
Income investors love this stock right now, even if everyone else doesn't. That's because this REIT is essentially a purpose-built income generation tool. Digital Realty enters into long-term triple-net leases with tenants, an arrangement that takes most of the risks off of DLR's balance sheet and puts the onus on tenants instead. The result is a predictable income stream and a hefty 4.3 per cent dividend yield right now. That, coupled with a high short interest ratio, make DLR a solid short squeeze candidate going into 2013.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes ,Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.
At the time of publication, author had no positions in stocks mentioned.