The Holy Grail of investing has always been spotting the bubble before it pops. Riding the wave of exuberance and selling out just before the market collapses has made billionaires and gurus, while leaving the rest of the buyers back where they started.

While most investors like to look for bubbles in stocks that Wall Street is hyping on the upside, most don’t realize it can work the other way around as well.#-ad_banner-#

Sometimes, a company can be so hated and be the target of so much negative sentiment, the herd piles on to push it further down. This is most commonly done through short-selling, or borrowing and then selling the shares with the promise to buy them back later. If the stock price retreats, then the short seller makes money.

But just as a market bubble can burst when there are no more buyers, a short-seller bubble can burst when there are no more sellers. You see, all the investors who borrowed the shares must buy them back at some point. If the company catches some good news, or at least less bad news as expected, then the short-sellers may not be able to find willing sellers without offering higher prices. This phenomenon is known as a short squeeze.

There are few better examples of this than the recent short squeeze of Netflix (Nasdaq: NFLX). The $10-billion movie rental and online-streaming service was facing competition rumors and a subscription policy gaffe in 2011. The company had 16.2 million shares shorted — 32.4% of the public float, as reported on Oct. 15, 2012. The stock was trading at $64.76 per share. News that investment guru Carl Icahn was going to invest in the company and that its financial data had improved since caused a 190% surge in the shares, thanks in part to short-sellers hurriedly closing out their position on more than 7 million shares.

Investors who spotted that this “short bubble” was about to pop made an incredible profit.

I’ve found three likely candidates with upside catalysts. (All short interest data from Nasdaq as of Jan. 31, 2013.)

1. Sturm, Ruger & Co.

Sturm, Ruger & Co. (NYSE: RGR) makes guns and, right now, the market hates guns. The sector has been beaten up during the past month in the lead-up to any possible federal legislation to restrict gun usage. Ruger has rebounded 35% from last December’s lows but is still off 8.5% from November highs. While new gun-control legislation is a likely scenario, the company should not be affected as a maker of non-assault weapons. Almost 90% of the shares are closely held by insiders and institutions, and shorts are already being squeezed by the run during the past month. Short-sellers have borrowed 6.8 million shares, about 36.8% of the shares available. The company is expected to post a gain of 94 cents per share when it reports 2012 fourth-quarter earnings on Wednesday, Feb. 27, representing a 74% increase from the same quarter in 2011. Ruger has beaten expectations in every quarter of the past 12-months by an average of 10 cents per share. Even at earnings expectations, the trailing earnings increase to $3.52 and bring the trailing price-to-earnings (P/E) ratio to 15.5. Revenue has increased an average of 26.6% annually during the past five years and is expected to increase by 44% in 2012 to $474 million compared with 2011. While the earnings report could present the catalyst for a short squeeze, the development of legislation that does not directly affect the company could be the biggest mechanism for upside in the shares.

2. Barnes & Noble

Barnes & Noble (NYSE: BKS) has been caught in the same nightmare that has tormented other brick-and-mortar retailers in the past few years. People are buying more books online, and investors are wondering where future revenue will come from. While the company has had negative net income since 2010, it still produces a significant amount of cash, not to mention that the pace of decline in the shares has slowed. Revenue has gone higher each year, while there has been substantial value in Nook e-readers and the overall brand. The similarities here with the proposed buyout of Dell (Nasdaq: DELL) are uncanny. Barnes & Noble founder Leonard Riggio still owns 35% of the $824.3 million brick-and-mortar bookseller. In all, insiders and institutional owners hold 86.9% of the shares. Short-sellers have borrowed 13.8 million shares, about 34.2% of the public float, leaving a deficit of shares available if the borrowed shares need to be bought back quickly. Nook sales doubled this past Black Friday compared with the previous year, and while unit sales declined slightly during the entire year, the product has been accepted as a legitimate competitor in the fast-growing tablet space. The tablet now accounts for 13% of company sales and is sold at many large retailers including Wal-Mart (NYSE: WMT) and Best Buy (NYSE: BBY). Liberty Media recently made a $204 million investment, and Microsoft (Nasdaq: MSFT) invested $300 million for a 17.6% stake in a subsidiary company. Earnings for the third quarter of 2012, which will be reported on Thursday, Feb. 28, are expected to be positive at 60 cents per share, but still well below 71 cents per share reported in 2011. The shares surged 51.7% to $20.75 on April 30 in 2012 on rumors that the company would split off the Nook business, leaving it more flexible to compete against other tablet makers. While the split never materialized, the price action gives investors an idea of how the market might value the sum of parts on the company.

3. The Sealy Corp.

The Sealy Corp. (NYSE: ZZ) saw its shares nosedive from more than $17 at the height of the housing boom to just 55 cents in 2009. The mattress and bedding company has never fully recovered from the housing bust, but shares have stabilized since 2010. Sealy beat 2012 fourth-quarter expectations for a loss of 3 cents a share with a net profit of 4 cents per share. The rebound in the housing market should materially support revenues in the future. Shares rebounded 37.5% in the three weeks leading up to third-quarter earnings but have been range-bound during the past five months. Revenue jumped 9.5% in 2012 to $1.35 billion and has been growing steadily since the housing crash in 2009. The problem here is annual interest expense of about $89 million on almost $800 million in long-term debt. The proposed merger with Tempur-Pedic International (NYSE: TPX) relieves the debt burden and would combine two of the strongest names in the industry. Insiders and institutional owners own 98% of the shares outstanding, leaving little room for the 18.3 million shares borrowed by short-sellers. Short interest in Tempur-Pedic is also high at 12.7%, with institutional and insider ownership also at 92.8% of shares outstanding. The Federal Trade Commission (FTC) has 45 days from Jan. 23 to review the merger. There is strong upside potential leading up to the decision as short-sellers close out their positions.

Risks to Consider: Despite the upside potential, there are still fundamental risks with the three companies going forward. Investors may want to set downside targets where they plan to cut their losses if the shares do not turn around over the next six months.

Action to Take –> Each of the companies above is set to jump higher in the event of any materially positive news. There are not enough shares outstanding to cover the amount that have been borrowed to sell short. Even a stabilization of the business could cause short-sellers to close out their positions and send the shares higher.