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Should You Consider a Stock's Short Interest When Investing?

The Motley Fool logo The Motley Fool 1/3/2022 Motley Fool Staff

In this segment of "The Morning Show" on Motley Fool Live, recorded on Dec. 13, Fool Senior Analyst Jim Gillies, Director of Small Cap Research Bill Mann, and Advisor Jim Mueller discuss some of the nuances of short interest for investors.

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Bill Mann owns Atlassian and Block, Inc. Jim Gillies owns Block, Inc. Jim Mueller, CFA owns Block, Inc. and has the following options: short February 2022 $220 calls on Block, Inc., short February 2022 $230 calls on Block, Inc., short February 2022 $90 puts on GameStop, and short March 2022 $230 calls on Block, Inc. The Motley Fool owns and recommends Atlassian, Block, Inc., Lemonade, Inc., and Tesla. The Motley Fool recommends Johnson & Johnson. The Motley Fool has a disclosure policy.

Jim Gillies: I think we have to high-five Ryan Reynolds too, and not just because he's Canadian. [LAUGHTER]

Bill Mann: He's amazing.

Gillies: I don't think it made it South of the border, but he just got, I think, it was the Order of Canada, Ryan Reynolds did, and they had the former lead singer of the Barenaked Ladies, Steven Page, write a song for him and perform it to welcome him. It's pretty great. Reynolds tears up pretty good.

Mann: Wow.

Gillies: You didn't see this. I'll find it for you and I will give it to you.

Mann: No, I did not see it.

Jim Mueller: You guys ever looked at the short interest when you're into companies? MKC asks, my trading platform provides short interest information from Nov. 30. For example, Square [now called Block (NYSE: SQ)] short interest of about 10 million shares, Lemonade (NYSE: LMND) about 36. Johnson & Johnson (NYSE: JNJ) about 63. What's the significance of this information? It seems that traders think Lemonade is going down and Square is a risk too. Please explain that.

Gillies: Who wants to take the first one on this one.

Mann: You go right ahead.

Gillies: Thanks. [LAUGHTER] Yes, I do look at short interest, but perhaps not for the reason you'd think.

I do short, I'm not currently short anything now. I look at short interest because quite often it can be a symbol of the market.

Again, to lever off of what Bill just talked about with Atlassian (NASDAQ: TEAM). It could be a sign that again, it's the market is not really understanding. For example, going into, prior to the GameStop (NYSE: GME) run-up last year, where I felt very lonely being the only person who said, I think this might be one of the pillars of the thesis for why you wanted to get into GameStop between $5 and $10, which is when I was advocating for it, was that the short interest was massive.

Certain people, including Time's today named man of the year, we're talking about their companies just having the highest short interest. No. No. No. No. GameStop. A, it had a massive short interest. B, if you did the math, they might have had more shares short than were outstanding.

Now, that doesn't necessarily mean there's naked shorting going on because I could own GameStop shares and I could lend them out. Jim Mueller borrows them from me and then shorts them. Someone else bought them from Jim, and then Bill Mann could borrow those ones from that other person and he could short them. That's not naked shorting.

There were so many shares outstanding, or shorted on GameStop than arguably were existing. Why that was interesting to me. Why I was looking at short interest to build my goal long thesis. Why that was interesting was because GameStop was cash-flow positive, had more cash than debt at the time. It's real hard for companies that are A, making cash, and B, don't have leverage risks. It's real hard for those companies to go bankrupt, which is what the shorts we're betting on.

Essentially the short interest in GameStop was so massive that I just said, "Look, if anything good happens at this company, shorts are just going to get slaughtered. Look what happens. What's that?

Mueller: Up to a point and then different mechanics took over.

Gillies: Then different mechanics took over, meme stock insanity, and whatever. But I got my people in it at $9 in Hidden Gems Canada and when the stock was $110. We have to take the end-of-day pricing. I think the stock was so volatile by that point. I think it closed at $70 or $80, but still at a $100. When I wrote the sell REQ and believe me, that was the fastest sell REQ I've ever written. The stock was at $100 bucks. I'm like, no we're taking our money and going. Calculus has changed. Buy me a beer next time you see me Fools.

Mueller: Then they yelled at you because it went to $300. [LAUGHTER]

Gillies: The number of people who did call for my, shall we say, losing my job by calling into our member services because I sold too early. That number is not zero Fools. [LAUGHTER]

But the other thing with short interest is for example if companies use convertible debt. Convertible debt, there's a particular type of investing hedge fund that will basically buy the converts.

Convertible debt is debt that converts into equity at a certain price. You get a lower coupon today, but you get the upside potential equity kicker. But what will happen is these hedge funds will buy the convertible debt and they'll short the stock in the precise amount of what the equity kicker is.

Then they lever up and they get the interest rate. But of course, they've levered 10-1 and you're getting two percent, that's 20% return minus whatever you're paying on your leverage. But this is also a clue you can use.

For example, the aforementioned company run by the guy named Time's Person of the Year today. He likes to at one point, extol the number of shorts in his company and kind of want to burn the shorts and burn the shorts, whatever. That would be Elon Musk Fools if you're not up on the news.

But in the last little while, and they talk about oh the shorts are just coming from Tesla (NASDAQ: TSLA). Last little while, if you look at Tesla's short interest and you look at the number of shares you have to be short because Tesla likes to issue convertible debt. If you looked at the number of shares shorted, that's basically the entire short market.

I don't know who Elon's railing against because all the shorts who think his company is problematic. Yes, I'm one of them, but I'm not short the company. They're sitting on the sidelines. They've been waiting for things to break.

These only shorts that exist are practically just tied to the converts. Those people are not shorting because they think the company is overvalued. They're doing it mechanically because of the strategy they're running.

There are reasons to look at short interest. But if your reason is, "Oh, these guys. Smart people short the stock, I should also short the stock." Just like that coat-tailing. Don't do that.

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