By Ari Charney on June 22, 2012

A beleaguered stock may be a tempting target for a short sale, but short selling can be an extremely risky pursuit. In order to short a stock, investors borrow shares and sell them to others with the hope of making money by buying shares back after theyve been beaten down.

But because of the markets tendency to rise a majority of the time, short sellers are often forced to cover these shares at a loss. Even worse, the losses from a short sale are theoretically unlimited, since there is no ceiling on share prices. That means the average investor has an opportunity to occasionally benefit from a short sellers woes. But doing so is likely almost as tricky as crafting a winning short sale.

Because of the risks entailed by short selling, most short sellers are typically seasoned, professional investors. And as Investing Daily senior editor Jim Fink has previously written. short sellers whove managed to survive over the long term are among the savviest investors, as the extraordinary difficulty of successfully executing a short-selling strategy quickly winnows out any untalented losers.

As a result, its worthwhile to monitor short-selling activity, as a significant shift in short interest can sometimes tip investors to trouble ahead. However, the exchanges vary in their provision of up-to-date information on a stocks short interest ratio a metric that expresses the number of shares sold short in terms of the number of days of the stocks average daily trading volume.

The Nasdaq and the Toronto Stock Exchange both report short interest data to the public on a lag based on semi-monthly data cut-offs. While the TSX only reports this data for the 20 firms with the highest levels of short interest and charges a fee for access to data for the rest of its listed securities, the Nasdaq allows investors to search this data for all stocks on its exchange. By contrast, the New York Stock Exchange charges for the most up-to-date short interest data, though services such as ShortSqueeze.com purport to offer a wealth of timely short interest data at a fraction of what it costs from the major exchanges.

Academic Studies: Short Sellers are Smart

There have been a number of academic studies on the consequences of short selling, and a 2004 study conducted by Harvard and MIT contains an extensive data set that covers more than two decades of stock market history. Once momentum gathers on the short side, it typically impairs a stocks subsequent performance. Indeed, the study found that the several dozen stocks with the highest short interest ratios tend to produce negative returns, while progressively lower short interest ratios only have a modest ability to predict future returns.

But the study also found that short interest can behave in a manner similar to investor sentiment, declining broadly near market tops and peaking near market bottoms. The same thing can also happen at an individual security level, where short interest reaches a peak and then rapidly declines because a positive news report about the underlying company triggers a short squeeze.

A short squeeze occurs when short sellers are forced to cover shares at a loss to avoid adding additional cash to their brokerage accounts to preserve the losing position. In such cases, the rapid succession of covering drives the share price higher and forces out additional short sellers, which causes an even further escalation in share price.

One of the more dramatic short squeezes in market history occurred in 2008, when shares of Volkswagen AG (OTC Markets: VLKAY) surged from EUR210 to over EUR1,000 over the course of just two trading sessions. That transpired after investors learned that Porsche decided to substantially increase its stake in its fellow German carmaker.

In Search of the Perfect Short-Squeeze Stock

But rather than rely on the fortuitous timing of corporate actions to precipitate a short squeeze, I was curious if there were any heavily shorted stocks that might nevertheless have compelling fundamental characteristics. To that end, I screened for US and Canadian equities with market caps of at least $1 billion that have a short interest ratio of five or more, and whose underlying companies had positive earnings growth and free cash flow, a current ratio of at least 1.5 or higher, a dividend yield of 2 percent or more and a payout ratio below 50 percent.

In other words, I was hoping to find unleveraged companies that could endure the depredations of short sellers, while compensating suffering shareholders with a solid dividend until its prospects improve.

Days to Cover vs. Percent of Float

Additionally, I compared a companys days to cover short interest against another type of short interest ratio defined as the percentage of a stocks overall float which is sold short. Float is the subset of a stocks shares outstanding that is considered available for public trading.

In particular, I was looking for the rare, fundamentally strong stock that has a high number of days to cover, but a low percentage of its float sold short. Such a stock would presumably be a potential candidate for a short squeeze since the high number of days to cover would be a significant obstacle in the event most short sellers need to quickly cover their shares.

And an underlying business with at least somewhat decent fundamentals could eventually report positive data that would be a catalyst for such an event. At the same time, I wasnt interested in a company where short sellers had ravaged an excessive amount of the stocks float, as that would be a more ominous sign that somethings gone awry with the business, while granting too much control to short sellers in the near term.

As an additional check, I also wanted to see that there were at least some insider purchases over the trailing three months, which would hopefully suggest that management expects better times ahead.

Results of Short-Squeeze Screen. Canadas George Weston

The one stock that cleared all these hurdles is the holding company George Weston (Toronto: WN.TO) (OTC Markets: WNGRF), which is best known for its nearly 60 percent controlling stake in Canadian grocer Loblaw (Toronto: L.TO) (OTC Markets: LBLCF). While 2 percent of Westons float has been sold short, the number of days to cover stands at 10, as of June 15. That span of time is generally regarded as the point at which it becomes difficult for short sellers to cover their positions en masse. The stocks short interest peaked in Mid-April, with more than 17 days to cover before dropping to the present level.

The company has 128.2 million shares outstanding, but with 63.1 percent of shares held by the Weston family, the stocks float is just 46.8 million shares. The stocks trailing three-month average daily trading volume is just under 82,000 shares, which explains why the days to cover are so high for a stock that has a relatively small percentage of its float sold short.

Weston currently yields 2.5 percent with a payout ratio of 31.5 percent, so the dividend should be well covered. Although Weston has just CAD200 million in long-term debt coming due over the next two years, it should be noted that Loblaw has CAD200 million in bonds maturing late next year and an additional CAD450 million due during the first and second quarters of 2014.

The company managed to beat analyst estimates by a decent margin in its most recent quarter, but the companys holdings have come under pressure from rising input and transportation costs. Additionally, Loblaw is investing in much-needed upgrades to its IT infrastructure and centralizing its supply chain to stave off incipient threats from Wal-Mart (NYSE: WMT) and Targets (NYSE: TGT) expansion into Canada. As such, earnings are forecast to decline modestly for the full-year 2012 from the prior year.

The firm has had elevated short interest since the middle of last year when Loblaw reported weak top-line numbers and later showed a drop in same-store sales, and then offered earnings guidance that was below consensus for 2012. Short interest declined sharply after the company reported first-quarter earnings, but Westons shares only enjoyed a modest bump before continuing their descent. Short sellers have pushed Westons shares down almost 32 percent from their 2011 high, and the stock trades near its 52-week low.

Loblaw is still in the midst of engineering a major turnaround, so Westons fortunes are largely hitched to whether management succeeds in this effort. While the dividend is attractive and seems stable, there are other far more attractive dividend payers in the Great White North.

And even when the company has had a high short interest ratio, the shares have not evidenced anything akin to a short squeeze. In fact, theyve merely headed lower. Although Weston trades well below Morningstars $75 per share estimate of the holding companys intrinsic value, the stock does not appear to be a short squeeze candidate. At best, its a value play for investors with a long-term horizon.

Nevertheless, I will continue to monitor this screen and report any promising short squeeze candidates in the future.