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A contrarian play: Get shorty

June 19, 2013: 9:20 AM ET
While betting on falling stocks can be risky, going against short-sellers can be smart.

While betting on falling stocks can be risky, going against short-sellers can be smart.

This article was published in the July issue of Money magazine.

You may think it's crazy to buy shares of companies that have a lot of people betting against them. Yet isn't that the very essence of contrarian investing?

Several stocks that have been recent targets of short-sellers -- investors who borrow shares and sell them, hoping to buy them back later at lower prices -- have been some of Wall Street's big winners this year. Among them: video-streaming giant Netflix (NFLX), electric-car maker Tesla Motors (TSLA), and Green Mountain Coffee Roasters (GMCR).

If they're so hated, why have they soared? In part, their shares have benefited from what's known as a short squeeze. If companies exceed expectations enough to push share prices up, that forces the shorts to rush back to buy the stock to cover themselves. That in turn drives prices even higher.

Related: When insiders buy stocks, should you?

Can you profit by going against the bears? Sure, but recognize that shorts are good at spotting trouble, especially if a company is overvalued. The trick is to identify stocks being unfairly punished that are bargains. The stocks highlighted here all fill that bill.

Coinstar (CSTR)

This change-counting company gets most of its sales from DVD rental firm Redbox. With Netflix on fire, some fear there's no room left in video. But Piper Jaffray analyst Michael Olson says Redbox's $1.20 rentals are still a much better value than cable on-demand viewing services.

Plus, Coinstar isn't sitting out the streaming revolution -- it has a partnership with Verizon (VZ) for online video. Olson expects Redbox's sales to rise 10% to 15% annually in the coming years.

GameStop (GME) and Take-Two Interactive Software (TTWO)

With games increasingly being played on cellphones and not TVs, the videogame retailer GameStop and software developer Take-Two have become targets. But there's still a big world beyond Angry Birds.

Related: 3 stocks people are buying now

"Investors think physical media like DVDs and videogames are dead, but the truth is they're not going away anytime soon," says Wedbush Securities analyst Michael Pachter, who recommends GameStop and Take-Two shares.

GameStop should see a boost in sales with the upcoming launches of Sony's PlayStation 4 and Microsoft's next Xbox. Take-Two is expected to have a monster hit when its fifth Grand Theft Auto game comes out in September.

USANA Health Sciences (USNA)

Hedge fund manager Bill Ackman is waging war against nutritional supplement maker Herbalife  (HLF), and other so-called multilevel marketers are getting caught in the crossfire. D.A. Davidson analyst Tim Ramey recommends USANA, another vitamin maker, with solid fundamentals. He notes that because the company's earnings growth and cash flow are so strong, it should defy the shorts.

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