This article was originally published on TheStreet.com on August 1st, 2014 at 1:19pm EST
“Short interest” is a measure for what percentage of a company’s outstanding shares are currently held short. Ok, so what does that mean? To short a stock means you must first borrow the shares, on margin, and then sell them along with the promise to buy them back at a later date. Until that later date, you pay interest on the shares you have borrowed from someone else. So the bet is that the stock is going down — at least, that’s how this trade makes money. It’s buy-low-sell-high in reverse.
There is some helpful information in monitoring the short interest for a stock you are watching. If the short interest is increasing it may be an indication that someone(s) has a strong feeling the stock is, or will soon be, in trouble. The mechanics of initiating a large short position also puts a great deal of downside pressure on a stock. Take a look at what’s happened with the most famous, and also infamous, short of the last year — Bill Ackman and Pershing Square Capital target: Herbalife (HLF).
You can see that as [Bill Ackman’s] short interest began to climb in 2012 the stock began its sharp decline, getting cut by more than half. But then we can also see that in the beginning of 2013 — when Carl Icahn, Dan Loeb, George Soros and others came out publicly on the other side of Ackman’s trade — short interest began to come down slightly and the shares climbed out of the cellar. Then short interest plunged almost exactly a year ago and the stock surged to all-time highs. Why did the short interest plunge in late 2013?
Better cover your shorts!
As the stock price started to rise in early 2013, Ackman’s short bet was becoming more and more unsuccessful. And more and more costly. Supposedly he sold short 20 million shares, which means every dollar increase in HLF’s stock price cost his investors $20mil (in addition to borrowing costs). At some point the short must be “covered” — remember the aforementioned promise the short seller made to buy back the shares at a later date. This is the only way to close the trade, whether or not it’s been profitable. Urgently buying back that many shares puts upward pressure on the stock. You can see Herbalife stock more than doubled in 2013….
Don’t let a short squeeze become a suicide squeeze.
Ackman has been accused of being doggedly determined, arrogant, and self-righteous — among other compliments — but he is certainly not interested in losing money on this bet forever. And neither are Pershing Square’s investors. So the stock will either go to zero and Ackman will be a hero, or more likely he will be forced to cover his short and buy back all the stock he borrowed. A short squeeze of this magnitude would be an enormous positive catalyst for Herbalife’s stock.
While the Herbalife scenario is laden with other risks, not least of which involve the company’s actual profitability and growth prospects, the same logic can be applied to the stocks of other companies. Another well-known company that was attracting a good deal of short interest over the past few years is Caterpillar (CAT).
It’s fairly clear that both times short interest peaked, and then retreated, over the past five years we have subsequently seen the stock move markedly higher. It should be noted that — regardless of what’s going on with Herbalife — short interest of more than 5% in a large company is substantial.
Now let’s take a look at a company that may not have yet benefited from a potential short squeeze, Atlas Pipeline Partners (APL):
Last year Atlas saw a spike in short interest as concerns grew over their mounting debt load coupled with the prospect of rising rates. There were fears that distributions at many smaller MLPs like Atlas would feel pressure if their cost of funds increased dramatically. As the short interest crept towards 10%, the stock fell from around $40 to below $30 in March.
But since the beginning of the year we have seen Atlas’ debt level plateau, and as their financial picture has improved and rates have actually dropped, they have been able to refinance debt and improve their cash flow. Just last week Atlas announced they were raising their quarterly distribution by $0.01, bringing their annual yield to 7.31% as of today’s close. APL also looks good from a technical perspective, with shorter-term moving averages having crossed its longer-term moving average to the upside recently.
This is not a broad recommendation to buy APL tomorrow at the open, and certainly not a recommendation to buy Herbalife. There are many factors in determining whether a particular stock, sector, or strategy is right for each investor.
The bottom line is that the market is no longer cheap, but doing one’s homework and being selective can still provide excellent entry points. Active investors may want to look for names with misplaced short interest for opportunities.
Have a great weekend and please let us know if there any way we might be able to help you….
Adam B. Scott
Argyle Capital Partners, LLC
www.argylecapitalpartners.com
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main
Adam Scott’s profile on TheStreet.com can be found here.
