These Healthcare Stocks Could Be Primed for a Short Squeeze

Source: Centers for Disease Control and Prevention.

As a whole, healthcare stocks have handily outperformed the broader market over the past five years.

But as the idiom goes, "the bigger they are, the harder they fall." Because healthcare stocks have done so well in this bull market, the most recent stock market correction, our first in four years, exposed them to some pretty harsh downside. Whereas some investors took the stock market correction as an opportunity to pick up high-quality stocks at a discount from where they'd been previously valued just weeks before, other traders, known as short-sellers, placed their bets firmly against the sector.

Short-sellers take aim at healthcare Since stock markets can move in either direction, short-sellers have just as much chance of being right over the long run as investors who buy and hold stocks with the expectation that they'll move higher.

However, short-sellers face three additional risks that optimists don't have to contend with. First, traders that bet against a stock have a maximum potential gain of 100% (stock prices can't go below $0), whereas their losses are unlimited. The reverse is true when you purchase a stock, in that your gains are unlimited and your losses are capped at the amount you invest.

Furthermore, short-sellers are required to use margin since they never actually own shares of the stock they're betting against. This means that not only are short-sellers' gains capped at 100%, but they'll be further eroded by the interest paid on the funds borrowed from their brokers.

But the third and potentially scariest risk of all is the danger of a short squeeze. A "short squeeze" is what occurs when positive news for a stock, or a simple rise in demand for a stocks' shares, sends the price of a stock rapidly higher and short-sellers get "stuck" in their positions. Short-sellers lose money when stock prices rise, and since their losses aren't capped they'll sometimes be looking to exit their positions (what's known as "buying to cover"). However, when stock prices are rising rapidly, exiting a posiiton can be difficult, and since shares need to be purchased to close the position it can push stock prices even higher.

Source: Flickr user Jim Makos.

Is a short squeeze imminent for these healthcare companies? Typically, the easiest way to determine if a stock is a short squeeze candidate is by examining its "days to cover," or the estimated number of days it would take short-sellers to exit their positions based on the number of short shares currently held by all traders divided into a stock's average daily volume. For example, if 100,000 shares were held by short-sellers, and the average daily volume of a stock was 20,000 shares, its days to cover would be five.

If you look closely at some of the most short-sold healthcare stocks and their days to cover, it's possible that some could be set up for a short squeeze. Today, we'll take a brief look at a handful of these highly short-sold stocks to determine if pessimists should be concerned, and what the long-term may hold for these companies.

Myriad Genetics : 32 days to cover Genetic diagnostic test developer Myriad, which is best known for its BRACAnalysis test to detect mutations in the BRCA1 and BRCA2 gene (these mutations lead to a higher risk of breast cancer and ovarian cancer in women), is a regular when it comes to garnering heavy short interest. It also boasts one of the highest days to cover, with 29 million shares held short and an average daily trading volume of 912,000 shares.

Source: Myriad Genetics.

The reason short-sellers continue to pile on Myriad is twofold. First, a handful of key patents to its BRACAnalysis test were invalidated by the Supreme Court in 2013, which allowed competitors to enter the market with rival BRCA1 and BRCA2 gene tests. Secondly, the Centers for Medicare and Medicaid Services, aided by Obamacare, is likely going to push reimbursement rates lower over the long-term. The hope, at least for short-sellers, is that this will put added pressure on Myriad's margins and stock.

In reality, I think short-sellers could be in big trouble here. Myriad has done a good job of diversifying its product and development pipeline, and it's benefited from a substantial number of its BRACAnalysis patients hailing from the private insurance sector. As personalized medicine continues to proliferate throughout the healthcare sector, it's probable, in my opinion, that interest in Myriad's products will increase. Although Myriad is no longer the inexpensive stock that it once was, product diversity and the trend toward personalized medicine make it a company I wouldn't dare bet against.

MannKind : 24 days to cover On the other hand, MannKind, a company that's developed a revolutionary inhaled diabetes product that works faster and leaves the body more quickly than many current standards of care, could be in serious trouble, and short-sellers might be in line for some hefty profits. At last check, MannKind was sporting 126.7 million shares held by short-sellers versus an average daily volume of 5.3 million shares.

Source: MannKind.

MannKind is quite the enigma because it has a product that looks like it should be a wild success on paper. Afrezza, its inhalable diabetes treatment for type 1 and type 2 diabetics, is a big step forward in convenience for patients who don't want to inject with insulin all the time. Because Afrezza metabolizes through the body faster than traditional insulin, it also could lead to fewer instances of hypoglycemia, which can be just as dangerous as having dangerously high blood sugar.

Yet through its first four months and change on pharmacy shelves Afrezza has racked up a minute $3.3 million in sales. As if that were not enough, MannKind doesn't even get this $3.3 million in revenue. Instead, it's netting just 31.5% of total sales, while licensing partner Sanofigets the remainder.

Furthermore, MannKind is already to the point where it's borrowing money to fund its shared losses with Sanofi over Afrezza. That's troublesome considering that MannKind's cash on hand is shrinking and Afrezza has shown little sign of taking off in the early going. With a valuation of $1.5 billion, I'd say MannKind shares still have plenty of room to deflate.

Insys Therapeutics : 20 days to coverLastly, Insys Therapeutics, one of the so-called "marijuana stocks," has nearly 16.2 million shares held short versus an average daily trading volume of 823,000.

Source: National Drug Abuse Research Centre.

Why the angst toward Insys? My suspicion is that it has a lot to do with the premium Insys' stock has generated since being lumped in with marijuana stocks. Insys is currently in the process of developing a CBD-based cannabidiol oral solution designed to treat two rare types of childhood-onset epilepsy. With Insys' stock up well over 1,000% over a three-year period, it's not hard to see why short-sellers have taken such exception.

But there's one big thing that pessimists are missing here: Insys generates practically none of its revenue from marijuana-based compounds. Instead, the company's breakthrough cancer pain sublingual therapy, known as Subsys, comprises 99% of its revenue -- and it has nothing to do with marijuana or marijuana research. Plus, Subsys has been growing quite steadily.

While Insys isn't exactly the cheap stock it once was, the simple fact that its sales could nearly triple to more than $600 million between 2014 and 2018 should provide some sort of buffer that minimizes its potential downside and could wind up coming back to haunt short-sellers.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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