Short sellers face two major risks when they bet against stocks, hoping they’ll sharply decline. First, their research needs to be right on the mark, correctly predicting negative future events will come to pass. Second, they hope and pray the broader market doesn’t rise in value. If that happens, then short sellers are often forced to cover their positions to avoid getting caught in a “melt-up,” and by doing so, they actually add buying pressure to the same stocks they are targeting for declines. That’s why it’s awfully risky to short stocks that are already heavily shorted by others. Even if your investment thesis is correct, then other short sellers may spoil the trade for you anyway by chickening out.

But if you look at it another way, these heavily-shorted stocks can make for very appealing “long” trades for investors, thanks to the added buying pressure that may come from short-covering. It’s still the early innings of earnings season, but if quarterly results — and outlooks — continue to be fairly impressive as they have been, then the market may just extend the recent rebound that began on Oct. 4.

The stocks to be most likely affected by heavy short covering are those with high short interest in relation to the trading float. (The number of shares outstanding minus shares held by insiders — basically, the actual number of shares (the float) that are free to trade on the market). Here’s a list of 17 stocks in which at least 30% of the float is held by short sellers — that’s a lot of stock that would have to be bought back if short sellers sought to cover their positions.

 

Of course, it’s understandable why so many people are short-selling some of these stocks — many still have considerable potential downside. For example, a pair of for-profit education stocks, Bridgepoint Education (NYSE: BPI) and ITT Educational Services (NYSE: ESI), may take further hits from enrollment drops as some potential students decide to forego higher education in this lousy economy.

In a similar vein, you can see the downside risk in KB Homes (NYSE: KBH) and McClatchey (NYSE: MNI), as housing and publishing both show no signs of turning around anytime soon. Yet three companies have caught my eye as potential short-squeeze candidates.

1. Teavana (NYSE: TEA)
With shares trading at around 45 times projected 2011 profits and three times sales, you can understand why short sellers think this operator of tea-focused cafes may seem overvalued. But this has the makings of a solid long-term growth opportunity based on an expansion of cafes in the U.S. and foreign markets. This concept isn’t in a crowded market like coffee chains.

The July 2011 initial public offering (IPO) was priced at $17, opened in the high $20s but eventually got pulled down by the tough market, to a recent $20 per share. Goldman Sachs’ analysts anticipate 25%-30% annual earnings per share (EPS) growth during the next five years as the company rolls out its base of stores.

It’s hard to see the quarterly risk in a business model like this. Existing stores follow a fairly predictable profit trajectory. Short sellers may be disappointed to discover that third-quarter results, due out in a few weeks, hold few negative surprises. And the company’s bulls — who were fully in evidence at the time of the IPO, may push the stock back up if the market rallies further, forcing short sellers to join the party.

2. Saks (NYSE: SKS)
Short sellers correctly note that the stock-market plunge has evaporated billions in value from the portfolios of wealthy consumers. They assume this wealth evaporation that began in July would lead the well-heeled to curtail spending. But during the past few years, it has been increasingly apparent that spending by the wealthy seems fairly immune to broader economic pressures. For example, Mercedes-Benz is on track for a record year in terms of U.S. sales.

That would also seem to be the message coming from high-end retailer Saks, which announced in early October same-store sales rose a lofty 9.3% in September, compared with the same period last year. This may help explain why Mexican billionaire Carlos Slim finds Saks so appealing. His investment firm, Inmobiliara Carso, which already owned more than 10% of Saks, snapped up another 900,000 shares at an average price of $7.90 in mid-August. [This isn’t surprising. We’ve found that many of the world’s billionaires drink from the same well over and over again. Warren Buffett, Bill Gates, Carlos Slim — and many, many others — keep buying what we call “forever stocks,” and make a fortune in the process. This special presentation has more details.]

If Slim moved to take over the rest of the company, then what might he pay? Analysts at Citigroup peg $15 a share as a fair price (50% above the current price), or 8.5 times projected 2012 EBITDA: “The multiple that we have assigned is approximately in-line with the median historical retail transaction multiple of 8.8x, which we view as appropriately conservative given SKS’ positioning as a high-end department store (Neiman Marcus was taken private for 9.3x).”

3. Collective Brands (NYSE: PSS)
Back in June, I noted management could unlock value at this footwear retailer by closing underperforming stores.
http://www.streetauthority.com/value-investing/retail-stock-too-cheap-ignore-458396

That’s precisely what the company ended up doing in late August. A move to focus on the most profitable stores has given shares a fresh boost to shares (though only back to the level I had initially recommended). Shares are still far too cheap and, as management’s turnaround plan takes root, short sellers may be forced to cover positions.

Analysts at DA Davidson agree, noting the current $14.75 share price looks too low by a pair of measures. First, they’ve done the math on an enterprise value/EBITDA basis and consider the stock is worth around $20.50. And on an EV/sales basis, they figure shares are worth $25. On the company’s next conference call, Collective Brands is likely to detail what its cost structure (and profit potential) will look like once the slated-for-closure stores have been shuttered. Short sellers may be disappointed that this shoe seller is a lot healthier than its lagging stock implies.

Risks to Consider: Short sellers may be targeting these companies for reasons that are not currently clear or obvious to the rest of the investment community. It pays to do ample research on these stocks to be sure there are no skeletons in the closet.

Action to Take –> A rising stock market is a great time to target heavily-shorted stocks. Any further gains could yield robust upward moves for these out-of-favor stocks.