By: Joseph Hogue of Street Authority
Rising interest rates is one of the most oft-referred-to topics on Wall Street right now. Some see higher borrowing costs as the straw that could break the market's eight-year bull run while others see it as needed counter-weight to emerging inflationary pressures.
Members of the Federal Open Market Committee (FOMC) already expects three rate hikes this year, and we may see more monetary tightening than that if fiscal stimulus jump-starts the economy.
Bond investments and dividend-paying stocks have sold off on a 33% jump in the rate on the 10-year Treasury since the beginning of November. Existing bond prices drop when rates increase and investors fear that higher rates will draw others out of dividend stocks for the relatively safety in fixed-income.
Financial companies have boomed on the increase in rates as the industry benefits from a wider net margin spread between borrowing and lending rates.
But few investors are paying attention to one segment of the market that could get an upside boost.
An Unexpected Winner From Higher Rates
Short sellers, betting on a drop in prices, have to pay a broker loan rate when they borrow shares to short. The rate varies by broker but can range from 2.5% to almost 9%, even on discount platforms. In addition to this, shorting some stocks may require a hard-to-borrow fee if the shares are already heavily shorted and illiquid.
As interest rates increase, it will get more expensive to hold short positions. Combine cost pressure from higher rates with the potential for stronger economic growth to lift stocks in general and you could see short-sellers reevaluate their bets.
January employment data came in stronger than expected even as wage inflation moderated. Fourth-quarter earnings for those reporting through last week have come in 5% higher than the same period last year. Any progress on tax reform could be a huge boost to the general market as lower taxes would lead to higher earnings across the board.
That pressure from higher borrowing costs on stocks with heavy short interest probably isn't enough in itself to drive prices higher, but it could be a major factor. It could even lead to a price-boosting situation known as a short-squeeze, which my colleague Nathan Slaughter covered in more detail here.
With the present momentum towards higher asset values, it won't take much to have short sellers seriously reconsidering their targets.
Three Short Targets With Upside To Run
I'm looking for short targets with strong balance sheets and potential catalysts that could initiate a pop in the shares. Beyond a strong balance sheet, high ownership by insiders and institutional owners can help support demand for shares. These closely-held shares reduce liquidity (shares available to be borrowed), making it more likely a price move higher could turn into a short-squeeze.
Sanderson Farms (Nasdaq:SAFM) is the country's third-largest chicken processor and sells 90% of its production domestically. Since there is no futures market for chicken prices, traders often turn to stocks to bet on lower prices and pure-play Sanderson Farms is a frequent target. Its exposure to faster U.S. economic growth and a trend to more meat consumption should drive sales, which have grown at a stable 1.6% rate over the last three years.
Institutional and insider ownership in the company is extremely high and it would take more than 11 days to cover short interest. The shares pay a 1% yield that short sellers need to cover on top of borrowing fees. The company has $234 million in balance sheet cash and no long-term debt, giving it a lot of financial flexibility.
Note: Insider and institutional ownership can be above 100% because of the way insiders are defined, as beneficial owners of 5% or more of the stock, can lead to double-counting.
Lending Tree (Nasdaq:TREE) is an online mortgage marketplace that connects borrowers and lenders. Shares plunged in early 2016 on poor performance and fears that higher interest rates would mean decreased mortgage lending. Daily stock volume jumped to over one million shares traded daily and short sellers pounced. Volume has since come down to normal levels but short sellers are still betting against the company, pushing the days-to-cover to over 13 days.
Much of the short position is likely institutional investors, hedging their 84% of shares outstanding in case mortgage lending cools. The company has $177 million in balance sheet cash, more than 13% its market cap, and is generating $24 million in free cash flow annually. Even at 4.2% on 30-year mortgages, rates are still low by historical standards and strong employment growth should drive home purchases.
GoPro (Nasdaq:GPRO) plunged last week on first-quarter revenue guidance of $200 million versus Wall Street estimates of $268 million. The company has suffered on a tough market for retail tech hardware but beat earnings estimates by a wide margin in the fourth quarter. The company has $225 million in balance sheet cash, 16% of its market cap, and no long-term debt.
GoPro announced late last year a restructuring plan that would cut 15% of staff and lower operating expenses to restore profitability. Even on a sluggish sales picture, the company still booked revenue over $1 billion over the last year. It has a strong brand in the action-camera market with a new voice-activated feature on the recently released Hero 5 model.
Risks To Consider: Rates are not the only factor that will influence short sellers. Stocks may weaken in the event of slower economic growth.
Action To Take: Take contrarian positions in some of the most-shorted stocks as higher borrowing rates cause short sellers to rethink their bets. These three short targets all have strong balance sheets and catalysts to the upside that could cause a short-squeeze.
Disclaimer: Joseph Hogue does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.