Are these 3 companies next for short cuts?

In March 2021, Reddit investors made headlines by sending GameStop (NYSE: GME) explode through a short press. Shorting a stock means betting against it, so the investor benefits as the stock price goes down. The short selling mechanism works by borrowing a stock from a shareholder at the opening price and then selling it back. The borrower closes his trade by buying a new stock which is returned to the original owner. For example, if I borrow a stock from you at $50 (opening a short position) and the stock then goes to $40, I made a profit of $10 because I borrowed and sold the $50 stock and returned the stock after buying it for $40.

If the stock price rises instead, many short sellers may be forced to close their bearish positions. Brokerages typically have automatic short sale liquidation rules in place, triggered by unreasonably large losses on paper.

A short squeeze occurs when many short positions are closed at the same time. Because there would be massive buying volume (to redeem the shares) and normal to low selling volume, the price increases due to the laws of supply and demand, sometimes causing another wave of closings managed automatically. And then the vicious cycle continues.

This action was overdone with GameStop, as 141% of the stock was sold short at its peak, meaning there were not enough stocks available to cover the short positions.

Image source: Getty Images.

While the days of short-interest over 100% are probably over, three stocks with high potential to short-squeeze due to large short positions are Lemonade (NYSE: LMND), Wayfair (NYSE:W), and GoodRx (NASDAQ:GDRX). All it takes is a catalyst of positive news for the short positions to be closed at the same time for a pop to occur.

Lemonade

With a short yield of 35%, Lemonade is the most shorted stock of the three. It is disrupting traditional insurance providers by using artificial intelligence (AI) to provide quotes in around 90 seconds and pay claims in three minutes. After starting in renters insurance, it expanded to include policies for homeowners, pets, term life, and auto insurance.

The shorts are betting against Lemonade due to its high valuation and unprofitability. Even though it is a technology-driven insurer, it is still an insurance company with extremely thin margins. The chart compares Lemonade to a software-as-a-service technology company with a similar profit margin.

Society Gross margin Profit margin Price/sales ratio
Lemonade 33% (19%) 21
Procore 82% (16%) 17

Data source: Limonade and Procore.

With a low gross margin, there is less room for operating expenses and profits. For this reason, companies with low gross margins often have a reduced valuation multiple. As the chart illustrates, the market still places a high value on Lemonade over a technology company.

One item that could trigger a short squeeze is a broad expansion of Lemonade’s auto insurance offering, as it’s only available in Illinois so far. This would accelerate Lemonade’s customer growth; in the last quarter, the number of customers increased by 45% to more than 1.3 million, compared to the figures for the previous year. Yet insurance is a slow business and change can be a hassle. Investors should play long with Lemonade, rather than hoping for a short squeeze in the blink of an eye and you miss it.

Wayfair

The pandemic has given Wayfair a huge boost. Many consumers were unwilling to enter a furniture store where others could have touched common surfaces. Instead, they turned to online retailers to spend their extra money on stimulus checks. Now that the surge has subsided, Wayfair is in trouble.

In the third quarter, its revenue was down 19% from a year ago, and it was not profitable this quarter despite making a profit last year. 22% of the stock is sold short, paving the way for a possible short squeeze.

Since it sells household items, most consumers do not make repeat purchases. The pandemic surge condensed much of this spending into a single period, skewing the results. On a positive note for Wayfair: active customers are up 1.5% year over year, showing that shopping for home goods online is not a pandemic fad.

Wayfair may generate a short squeeze this year by reporting strong revenue growth – which could happen as its results won’t be compared to inflated pandemic numbers. Additionally, a surprise profit could send the stock skyrocketing.

GoodRx

GoodRx offers its users the best prescription cost available. The company estimates it has helped fill at least 80 million prescriptions that otherwise would not have been filled due to cost alone. Customers love GoodRx, which is reflected in its incredible Net Promoter Score – a measure of the number of users who advocate for the brand – of 90, a world-class score.

Revenue growth in the third quarter was solid at 25%, but its subscription offering segment stole the show growing 111% year-over-year. Although it only represents about 10% of total revenue, continued growth will make it a much larger part of the business.

Short-term interest sits at 21%, but this may be due to recent strong growth/disposal of unprofitable stocks.

Graph showing the decline in GoodRx's PS ratio since early 2021.

PS GDRX report given by Y-Charts

With its lowest public valuation, buyers could start buying this stock at depressed prices and potentially trigger a short squeeze.

GoodRx nearly made a profit in the third quarter, with its net margin just -9%. It has plenty of room to work with with its astonishing gross margin of 94%. If it reduced its heavy sales and marketing expenses – 49% of its revenue – GoodRx could turn a profit and make the shorts head for the exit.

With all three companies, short cuts are possible. However, this only provides one short term pop. Investors need to look at the company for a better investment thesis than just the possibility of a short squeeze. If the crunch never happens, the company will have to run on its trading side to deliver strong returns. And if that does materialize, it may take an inhumanly precise trigger finger on the “sell” button to capture the sudden rise in value. While I’m not sure how Wayfair will thrive in the post-pandemic world, GoodRx and Lemonade have big industry trends on their side.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end consulting service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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