Shares of heavily shorted stocks occasionally see face-ripping rallies, but they typically underperform boring benchmarks like the S&P 500 over time
Shares of heavily shorted stocks are surging once again on Monday, following a Reddit post from an account long associated with Keith Gill, the trader widely credited with stoking the original meme-stock mania in 2021.
But before investors are tempted to jump in and buy, one quantitative analyst would like to offer a word of caution: While shares of these companies can occasionally yield thrilling gains - indeed, shares of GameStop Corp. $(GME)$ soared on Monday after Gill's Reddit account disclosed a position allegedly worth nearly $400 million shortly after Wall Street opened - over time, investing in these companies is likely to lose money, or at least lead to disappointing returns compared with what investors can realize by investing in a boring index fund tracking the S&P 500 or some other broad benchmark.
"In other words, the short sellers are generally right about these stocks, but market dynamics can make holding those shorts extremely painful during certain periods," said Lionel Smoler Schatz, a quantitative analyst at Verdad Advisers, in a report shared with MarketWatch on Monday.
This makes intuitive sense, given that shares of heavily shorted companies often report spotty or nonexistent profits, if not consistent losses.
But in the report, Smoler Schatz furnished data to support this point, creating a basket of the most heavily shorted stocks and comparing its performance with a broad-market benchmark. He found that despite the occasional face-ripping rally, heavily shorted stocks tended to dramatically underperform over time.
What's more, heavily shorted names typically underperform on both an absolute and risk-adjusted basis.
But this doesn't mean betting against them is a wise strategy, either. As the chart below shows, the gains these stocks experience during a short squeeze are typically orders of magnitude higher than the steady daily declines seen over time.
This can make holding short positions particularly painful, or at least more trouble than it is worth.
Because of this, Smoler Schatz recommends that any investor who is looking to trade using short interest as a guide consider betting on names of companies with low short interest, rather than betting against companies where short interest is high. He noted that there is ample academic research supporting the notion that stocks with low short interest outperform over time.
He also recommended that aspiring short sellers should keep the collapse of hedge fund Melvin Capital in mind. The hedge fund famously booked billions in losses on its short bet against GameStop during the original meme-stock bonanza, forcing it to accept an infusion of outside capital. A little over one year later, the fund's founder announced he was returning money to investors and shutting down.
"The fall of Melvin Capital reminds us that even a six-foot fund manager can find himself drowning in a river that has an average depth of three feet," Smoler Schatz said.
Shares of companies with high short interest, according to MarketWatch data - among them MicroCloud Hologram Inc. (HOLO), Children's Place Inc. $(PLCE)$, Phathom Pharmaceuticals Inc. (PHAT), Beyond Meat Inc. $(BYND)$, Petco Health & Wellness Co. $(WOOF)$ and Faraday Future Intelligent Electric Inc. (FFIE) - were all trading sharply higher Monday afternoon.
Meanwhile, GameStop shares had pared a nearly 100% premarket advance that briefly saddled short sellers with nearly $1 billion in paper losses, according to data from StockTwits.
Shares of the videogame retailer were still up nearly 35% in recent trading, while the S&P 500 SPX was down 20 points, or 0.4%, at 5,256, and the Dow Jones Industrial Average DJIA was off by 300 points, or 0.8%, at 38,380, according to FactSet data.
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