Short sellers sell stock that they don’t own in the hopes of buying it back for a much lower price at a later date. Several studies have concluded that short selling reduces market volatility and improves liquidity. For example, Yale professor Owen Lamont wrote in Go Down Fighting: Short Sellers vs. Firms (2004):

Many of the sample firms are subsequently revealed to be fraudulent. Thus the short sellers are identifying firms having bad fundamental value. This paper has presented a rogues gallery of shady characters, ranging from Charles Keating to Adnan Khashoggi. In public battles between short sellers and firms, short sellers usually are vindicated by subsequent events. The evidence suggests that short sellers play an important role in detecting not just overpricing, but also fraud. Policy makers might want to consider making the institutional and legal environment less hostile to short sellers.

Lamont discusses examples of companies that sue short sellers for stock manipulation and found that such companies underperform the general market by 25 percent in the year following their lawsuits. His advice is to avoid companies that sue short sellers. All one has to do is look at the price performance of companies such as Solv-Ex, Overstock.com, and Biovail — now part of Valeant Pharmaceuticals (NYSE: VRX) — after they sued short sellers to conclude that short sellers were right.

Short Sellers are the Smart Money: Pay Attention to Short Interest Ratios

The benefit of short selling goes beyond increased trading liquidity, however. It turns out that short sellers are on average an extremely smart group of equity analysts and it pays to be aware of what they are shorting. You’ve got to be smart to survive as a short seller given all of the impediments regulators place in their way, not to mention the hostility of companies that sue them and the risk of short squeezes when lenders of stock decide they want the stock back. The Economist magazine calls the life of a short seller “nasty, brutish, and short.” But the best short sellers survive and thrive and are considered the “smart money.”

A 2004 MIT and Harvard study entitled Short Interest and Stock Returns concluded that

Our results indicate that the only class of stocks that reliably produce negative abnormal returns is that of small cap firms with extremely high short interest ratios. An investor selecting stocks for a portfolio should avoid stocks with a high short interest ratio. If an investor already owns a stock that develops sustained high short interest, the clear and strong advice is to sell the stock immediately.

“Short interest ratio” is defined as the number of shares shorted divided by the number of shares available for trading (i.e., the public float). The study found that stocks with the highest short interest ratios (99th percentile) underperformed on average by 125 basis points per month (15% per year). To qualify for the 99th percentile, the stock typically has a short interest ratio of 20% or higher. You can find the short interest for any Nasdaq stock by clicking here. The NYSE appears to charge for the most up-to-date short interest information (Bloomberg gets delayed data), but that’s okay because the study found that the negative relationship between short interest ratios and subsequent performance is strongest with Nasdaq stocks.

Stocks with the Highest Short Interest Ratios

Below is a list of the 10 stocks with a market cap of at least $250 million that have the highest short interest ratios:

Source: Bloomberg

Short sellers aren’t always right, so some of these stocks might turn out to be good investments. But with this significant short-selling chip on their shoulders, avoidance is the easy solution for investors. Brave souls looking to profit from a short squeeze can consider buying in, but substantial due diligence research is recommended prior to pulling the trigger.

At Roadrunner Stocks, I respect high short interest ratios, but also have the confidence to go against the short-seller crowd when I feel they are wrong. When short sellers are wrong, they are really wrong and short squeezes can cause stocks to skyrocket higher. Right now, three Roadrunner recommendations (WNR, BKE, CRR) have short interest ratios above 20 percent that I believe are excellent businesses with short-squeeze potential.

Around the Roadrunner Portfolios

Gentex (Nasdaq: GNTX) increased its quarterly dividend by 8 percent to $0.14 per share. Returning cash to shareholders is a sign of corporate health, as well as a management dedicated to generating wealth. As CEO Fred Bauer stated:

We have a history of paying out a significant portion of our earnings in dividends — approximately 50 percent — and we continue to believe that an investor-friendly dividend rate should be meaningful, sustainable and increase over time, at a rate generally in line with the Company’s net income and operating cash flow. 

Amen. I wish all corporate CEOs felt this way.

HMS Holdings (Nasdaq: HMSY) reported excellent fourth-quarter financial results and the stock jumped 9.1 percent on the news. Earnings beat analyst estimates while revenues matched expectations. CEO Bill Lucia said that the “challenging” year of 2012 was now behind the company and that 2013 looks much better:

So we begin 2013 not only with a strong core business, but also with significant early stage opportunities across the company, including implementing our Medicaid RAC contracts; expanding our footprint in the fraud, waste, and abuse and analytics market; and taking our eligibility verification services to the States and their new health insurance exchanges. These initiatives, together with our leadership in both Medicaid and Medicare, and a steadily growing presence in the commercial market, position us well for delivering sustainable growth in 2013 and for years beyond.

Analysts were worried that the company would reduce 2013 revenue guidance because the award of the Medicare Coordination of Benefits contract to HMS was being protested by the incumbent provider and is under Centers for Medicare & Medicaid Services (CMS) review — a review that may not be completed until the third quarter of 2013. But the company did not alter its previously-issued 2013 revenue guidance, which was a pleasant surprise. On the positive earnings news and outlook, the stock was upgraded by both Dougherty & Co. and TheStreet.com.

Ocwen Financial (NYSE: OCN) is a favorite holding of two billionaire hedge-fund managers: Julian Robertson and Israel Englander — according to recently filed 13F reports. Despite the stock’s strong price momentum, its current price is only 8 times consensus earnings for 2013.

United Therapeutics (Nasdaq: UTHR) announced excellent fourth-quarter financials that blew away analyst earnings estimates by a whopping $0.40 per share and beat on revenues also. Forward revenue guidance for 2013 was re-affirmed at $1 billion. Full-year earnings per share were $5.84, which means that the stock is currently trading at a P/E ratio below 10. Such a low valuation is pretty crazy given that the company’s business is in a strong growth mode, with fourth-quarter earnings more than doubling and full-year 2012 earnings up 56 percent! According to CEO Martine Rothblatt, one of the most impressive results in 2012 was the fact that:

Our medicines are now being prescribed to more pulmonary hypertension patients in the United States than any other company’s medicine. That’s a high watermark that we’ve achieved against other companies which are much larger and better capitalized than we. I think the reason for this is completely due to the fact that physicians over time have found that the United Therapeutics medicines are the ones that they can rely on to provide superior results for their patients.

Also noteworthy were Ms. Rothblatt’s comments concerning oral treprostinil — the holy grail of PAH treatment — which:

We continue to be very, very excited about. We’ve got a game buster clinical trial going on right now. We’re enrolling over 850 patients. All of the major pulmonary hypertension centers in the world are participating in this study. We believe it’s going to result with a statistically significant outcome, showing a delay to clinical worsening when oral treprostinil is dosed in combination with other drugs, which will certainly validate the blockbuster potential for that drug. 

My personal belief is as long as we persistently do everything which is right and necessary, oral treprostinil definitely will get approved. And I know it sounds kind of silly to say quitters never win and winners never quit, but we are winners here and we’re not going to quit on oral treprostinil.

Non-Portfolio Update:

3D Systems (NYSE: DDD) closed down 9% (after falling 20% intraday) on Monday February 25^th after missing inflated analyst expectations for revenues. Q4 revenue growth of 45% and Q4 earnings growth of 44% evidently wasn’t good enough.

Please note that I didn’t recommend buying DDD in The Next Apple premium report that my research team and I recently wrote, which is why the stock has not yet been added to the Roadrunner Momentum Portfolio. To quote from the premium report:

At a current price-to-earnings ratio of 78.5, 3D Systems is very expensive by historical standards. Even assuming that the industry can continue to grow 30% annually for the next decade, the PEG ratio of 3D Systems is high at 2.5 times.

With the recent price decline, 3D Systems’ stock valuation is looking more attractive, and the 3-D industry in general continues to have a very bright future of growth. It’s worth remembering that Apple suffered through several scary declines on its stock’s long road to becoming a 40-bagger. But I like to give stocks time to stabilize after a price decline, so DDD and other 3-D printing stocks will remain on my watch list for now.