3 wildly shorted stocks worth buying

Not all heavily shorted stocks are to be shunned.

By InvestorPlace Apr 25, 2012 10:00AM

By Will Ashworth


Bespoke Investment Group recently came out with a list of the most heavily shorted stocks in the S&P 1500. To qualify, a company had to have at least 25% of its freely floated shares sold short.


Topping the list at 53.1% is Diamond Foods (DMND), the California snack food company that crashed and burned earlier this year because of accounting malpractice and a botched deal to buy Pringles from Procter & Gamble (PG). Diamond is so beaten down, it's a tempting buy. I'll pass, however, and recommend instead these three shorts that I think are buys:


Let the squeeze begin!


GameStop

GameStop (GME) has 6,683 stores worldwide. In the last three fiscal years, it spent approximately $516 million opening 1,032 stores. The shorts argue that GME is throwing good money after bad and that eventually it will end up like Blockbuster. They further suggest that GME isn't investing enough in its digital platform, which is the future of video games. Let's address those concerns.


In 2011, GME reduced its store footprint in the U.S. by 1% and slowed its international store expansion. In 2012, it expects to open 100 stores in the U.S. while closing 150. Internationally, it will open stores, though square footage will remain flat.


GameStop has become far more selective about where it puts its stores. Convenient locations where customers can buy and sell used video games help promote new software, hardware and downloadable content. Not to mention that gross margins on used video games were 46.6% in fiscal 2012 -- more than double those for new games. Eliminate physical stores and you can kiss a good portion of those sales goodbye.


As for its digital platform, GME grew digital receipts by 57%, to $453 million, in 2011. By 2014, it expects digital revenues to be $1.5 billion -- a 50% compound annual growth rate from 2010 to 2014.


In the span of three fiscal years, it has expanded gross margin of its "other products" category, which includes digital, by 600 basis points, to 39.8%. In three more years, I could see that number being in the mid-40s. If that happens, and GME generates the $1.5 billion in revenue it's projecting, digital alone will generate gross profits of $675 million.


With GameStop's financial condition as strong as it's ever been, I see its transition to online gaming as a profitable one -- without sacrificing the chain's physical presence. The shorts be damned.


Boston Beer

Approximately one-third of Boston Beer's (SAM) free float is shorted at the moment. Over at the Yahoo Finance message boards, the consensus seems to be that the valuation and increased competition are the primary reasons investors are shorting its stock.


While it's true that Jim Koch and the rest of his Sam Adams team are facing new entrants almost every day in the craft-brewing business, it's hard to imagine that a bunch of start-ups are going to seriously challenge the biggest craft brewer in America.


California's Sierra Nevada and Colorado's New Belgium have recently announced that they're each spending $75 million to open East Coast breweries to challenge Boston Beer in its own backyard. Why? Craft beer is facing a renaissance like never before. In 2011, craft beer output increased 16.4% by volume, while the industry as a whole shrank 2%.


So, there's plenty of room at this party, and the increased competition only makes Boston Beer a more attractive acquisition for a big brewer such as Anheuser-Busch InBev (BUD). Similar to Monster Beverage (MNST), SAM has a premium valuation because it has several suitors. When Koch is ready, he'll set the terms under which the brewer will lose its independence. Until then, he's king of the castle.


Saks Fifth Avenue

In the not-so-distant past, luxury department store Saks Fifth Avenue (SKS) was struggling. Not anymore. Since December 2009, it has achieved 28 consecutive months of same-store sales growth year-over-year.


Investors who are shorting its stock must be convinced that the end of the world is near, because I see nothing that portends a collapse in Saks's business.


While the economy has been slowly rising from the ashes over the past two years, it's important to remember that a vast majority of Americans are working and have been throughout the slowdown. More important, wealthy consumers are spending. The results speak for themselves.


In fiscal 2011, Saks earned $74.8 million on $3 billion in revenue. That's its best bottom-line performance in a decade. Its operating margin, at 4.9%, also was the highest it's been in a very long time.


The Fifth Avenue store generated approximately $660 million in 2011, or 22% of sales. That works out to $1,000 per square foot. Not many department stores can match those kind of numbers.


Mason Hawkins, the longtime money manager and founder of Southeastern Asset Management, holds 14.3 million Saks shares in his Longleaf Partners Small-Cap Fund (LLSCX). Hawkins knows a thing or two about value. Shorting Saks is almost as puzzling as shorting Boston Beer. I just don't get the attraction.


The important lesson to gleam from this: If used right, short interest can be your guide to opportunity.


As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.


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1Comment
Apr 25, 2012 1:05PM
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I'd be very leery of Gamestop.  Rumor is, both the Microsoft (Xbox) and Sony (Playstation) next generation gaming consoles will implement measures to prevent the use of used games.  Of course, those are only rumors, but game developers and publishers would like to see the used game market disappear. 
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