Heavily shorted stocks with strong free cash flow could be outperformers in a bear market rally, according to Evercore. The firm issued a list of stock ideas Monday that it expects could do well based on their high free cash flow and large short positions. "It's been said that cash is a liability in a high inflation environment," said Julian Emanuel, head of equity, derivative and quantitative strategy at Evercore. "Not only do we disagree vehemently, we want stocks that throw off cash and we want stocks that people continued to short the whole way down. Those are the names we think have a very high conviction chance of outperforming in a bear market rally that we think has further to run." Evercore screened for stocks that had $5 billion or more market capitalization, as well as strong free cash flow and high short interest that's in the top quintile of their range for the past year. "It's important because in a bear market you need every advantage you can find," said Emanuel. "It's basically high free cash flow yield names with high short interest...They did not make lower lows in June while the index did." The findings were diverse, coming from a wide range of industries. For instance, in the communications services sector, Google parent Alphabet was on the list, with its estimated 5.3% free cash flow this year. Several consumer discretionary companies made the screen, including cooking and home goods retailer, Williams-Sonoma. The company's estimated free cash flow is 12.8% this year, and its stock is more than 43% from its peak. Energy company Antero Resources made the list, with strong 25.3% estimated cash flow this year. The natural gas and oil company's stock is down nearly 28% from its peak. Health care firm Azenta and industrial Knight-Swift Transportation were also on the list. Azenta's estimated free cash flow is nearly 30%, while trucking company Knight-Swift's is expected at 11.1% this year. After a 6.4% bounce last week, the S & P 500 was little changed Monday. Emanuel said stocks could continue higher for a few more weeks and the market may have seen a bottom but that it's not clear it was the low in the current cycle. Crypto currencies may already have set a bottom, he noted. "Our view is [stocks] are likely to run into the [July] Fed meeting. Could [the market] turn over into the Fed meeting? Of course," he said. "Our base case is this is a bear market rally and by definition it's going to end at some point. We don't want people to get over their skis for how to think about it." Emanuel said it's not clear the stock rally will actually stall when the Federal Reserve next meets on July 26-27, but it could. Many strategists expect the market to sputter again when second quarter earnings are released starting midmonth. "We are making the case a week ago was a bottom. Not the bottom," he said. In a bear market, investors need to think about whether any potential rally is tradeable or sufficiently investable. "We believe the answer is yes. If you're a long-term investor you should be buying down 20%." At its June low, the S & P 500 was down 23.9% from its January high.
A Google sign is pictured during the company's presentation of a detailed investment plan for Germany outside the Google office in Berlin, Germany, August 31, 2021.
Annegret Hilse | Reuters