For much of the past three months, retail investors have been the talk of the town on Wall Street.
Since mid-January, predominantly young and/or novice investors on Reddit’s WallStreetBets chat room have been banding together to buy shares and out-of-the-money call options in stocks that have high levels of short interest. Short-sellers are investors who want to see share prices decline. Though stocks move in both directions, short-selling comes with the added risk of losses being unlimited.
A successful short squeeze requires the right recipe
The goal for these retail investors has been to effect a short squeeze. This is an event where short-sellers (predominantly institutional investors and hedge funds) get pressured out of their position by a substantial run-up in the security they’re betting against. With pessimists rushing the exit at the same time and needing to buy shares to cover their position, it tends to exacerbate the upside move in a stock.
For example, short squeezes were responsible for sending video game and accessories retailer GameStop (NYSE:GME), movie theater chain AMC Entertainment Holdings (NYSE:AMC), and Canadian marijuana stock Sundial Growers (NASDAQ:SNDL) to the moon, metaphorically speaking.
But the dynamics of short squeezes are always changing, and what worked for GameStop, AMC, and Sundial two months ago is highly unlikely to work now.
For example, GameStop’s short interest (the total number of shares held short, relative to its tradable shares, known as the float) fell from a triple-digit percentage in mid-January to 22% by mid-March. Meanwhile, AMC Entertainment and Sundial have short interest of only 12% and 10%, respectively.
The other ingredient necessary for a short squeeze is a high days to cover, also known as short ratio. The longer it takes short-sellers to exit their positions, the more likely they are to feel trapped. When this “trap” occurs is when share prices rocket higher. Due to the exceptionally high daily trading volumes for GameStop, AMC, and Sundial, short-sellers could easily exit their position in a matter of hours, should they choose to do so.
This trio of companies could put a hurting on short-sellers
Although GameStop, AMC, and Sundial are no longer good candidates for a short squeeze, it doesn’t mean other potentially off-the-radar stocks aren’t. The following trio of stocks might all be primed to squeeze pessimists.
First up is content delivery and security specialist Fastly (NYSE:FSLY), which happens to be one of the fastest-growing tech stocks. As of mid-March, 20.3 million shares were held short, representing 22% of the company’s float. More importantly, with an average daily trade volume of 5 million shares, it would take short-sellers four full days to exit their positions. That’s a solid recipe for a short squeeze.
What’s impressive about Fastly (unlike AMC, GameStop, and Sundial) is that you’ll find operating growth to back up the idea of a short squeeze. With more businesses than ever shifting to an online presence, the demand to quickly deliver content to end users is only expected to grow. With a usage-based operating model, Fastly should be able to triple its sales over the next four years.
The Fastly business model has clearly demonstrated the ability to scale with its clients. Dollar-based net expansion rates for the third and fourth quarters were 147% and 143%, respectively, which denotes that existing clients spent 47% and 43% more than they did in the year-ago quarters. The company sports a retention rate of 99% as well.
We’re just witnessing the tip of the iceberg for edge cloud stocks like Fastly. Another exceptional quarter of growth could be all it takes to flatten short-sellers.
Biotech stock Intercept Pharmaceuticals (NASDAQ:ICPT) is another intriguing short-squeeze candidate. Intercept had 7.24 million shares held short as of mid-March, which equates to nearly 26% of its float. The key here is that it only trades around 1.16 million shares per day. This implies that it would take more than six trading sessions for short-sellers to completely exit their positions if Intercept’s stock moved sharply higher.
The potential for a squeeze is going to depend on experimental treatment obeticholic acid (OCA) for nonalcoholic steatohepatitis (NASH). NASH is a liver disease that affects up to 5% of the U.S. adult population, and can lead to fibrosis, cancer, or even death. It currently has no cure or therapies approved by the Food and Drug Administration.
On the bright side, OCA met one of its two co-primary endpoints in the late-stage Regenerate trial — a statistically significant improvement in fibrosis without a worsening of NASH. On the other hand, the high (and most effective) dose led to increased instances of pruritus (itching) and considerably more trial dropouts than the placebo. The FDA sent Intercept a Complete Response Letter, requesting additional safety data on OCA.
With new trial data upcoming, Intercept could obliterate or affirm the short-sellers’ thesis. Even if OCA is approved for a small subset of the sickest NASH patients, it could easily become a blockbuster in what’s been deemed a $35 billion indication.
Lastly, technology-driven insurance company Root (NASDAQ:ROOT) has the potential to exact one heck of a short squeeze on pessimists. Root had 10.92 million shares held short as of mid-March, representing almost 41% of its float. Considering that Root’s average daily trading volume is less than 3.2 million shares, it would take just shy of 3.5 trading days for short-sellers to complete their exodus.
The Root auto insurance model is unlike anything we’ve seen before. The company is relying on telematics to get a bead on important safety characteristics of drivers before they become customers. By utilizing information derived from the magnetometer, accelerometer, and gyroscope in a user’s smartphone, Root can determine how safely or aggressively people drive and offer them a policy based on these extensive metrics.
As you might imagine, the concept is getting a lot of buzz, but it’s also generating substantial losses at the moment. Root is expecting its operating losses in 2021 will range from $505 million to $555 million, with the company ramping up the marketing campaign that was cut back considerably during the pandemic last year. Then again, Wall Street foresees a quadrupling in sales between 2020 and 2023, which is nothing to sneeze at.
A short squeeze in Root could be triggered by something as simple as higher-than-expected sales growth, or possibly the company’s loss ratios coming in better than expected, which would validate its data-driven operating model.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.