It sounds counter-intuitive – maybe even daring – but Deutsche Bank thinks you should take on the short sellers during next month's reporting season.
The broker said that companies that are targeted by short sellers tend to outperform when they release their profit results. According to Deutsche, the top 10% of the most shorted stocks on the S&P/ASX 200 (Index:^AXJO) (ASX:XJO) have outperformed the market 80% of the time by an average of 2% over the past seven years.
Short sellers borrow stock to sell in the hope of buying it back at a lower price later on to profit from the difference.
There could be a few reasons why the most shorted stocks outperform the market. Perhaps it's the tendency for investors to "buy the rumour and sell the fact". Or in the case of short sellers, "sell the rumour and buy the fact" as they are betting on an outcome of the profit results and will generally close their position regardless of the result.
Deutsche also reckons that most of the short-sold favourites actually manage to deliver better-than-expected results and that only 40% post a disappointing result. All the more reason for short sellers to close their positions by buying the stock. If enough of these short sellers close their positions, it will lead to a "short squeeze" where demand for the stock outstrips the supply.
This could be good news for a number of miners and retailers as they dominate the list of our most shorted stocks. These include department store Myer Holdings Ltd (ASX: MYR), electronics chain JB HI-Fi Limited (ASX: JBH), gold and nickel miner Independence Group NL (ASX: IGO) and food and beverage franchise operator Retail Food Group Limited (ASX: RFG).
But buying the most shorted companies may only work in the short term, as Deutsche said the effect only lasts two months on average.
Those with a longer investment horizon can also benefit from the thematic if they are more selective and pick only the most shorted stocks with the brightest fundamentals.
From that perspective, the broker notes the stocks it has a "buy" recommendation on that are heavily short sold are JB Hi-FI and its rival Harvey Norman Holdings Limited (ASX: HVN), auto retailer Automotive Holdings Group Ltd (ASX: AHG), telco TPG Telecom Ltd (ASX: TPM), and miners Independence Group, Orocobre Limited (ASX: ORE) and Syrah Resources Ltd (ASX: SYR).
