Going “short” a company involves selling shares that you have borrowed from another investor (for a fee) with the expectation that you can buy them back at a lower price in the future.

#-ad_banner-#People who short shares of a company are betting that those shares are going to drop in price.  

Short selling is a much riskier business than owning shares of companies.  

If you buy shares of a company, the most you can lose is the full amount you have invested.  If you invest $5,000, the worst thing that can happen is that the stock goes to zero and you lose your investment.

Meanwhile, if you were to short $5,000 worth of shares of the same company, your potential for loss is much greater. A stock price can double, triple — or go up 10 times in price. In fact, there is no limit to what your potential loss could be.

Because short selling is such a risky business, the people who practice it are generally some of the smartest people in the market. They have to be, because if they don’t do their homework, they usually get taken to the cleaners — quickly.

For me, a high short interest is usually reason enough to steer clear of owning a stock. I’m not interested in taking the opposite side of a trade from smart short sellers.

Every once in a while, however, I see an opportunity to own shares of a highly shorted stock that interests me. Taking a long position in a company that short sellers have made a mistake on can be hugely rewarding.

I’m of course talking about being on the right side of a short squeeze.

One successful value-oriented edge fund manager, Whitney Tilson of Kase Capital Management, recently revealed that he owns shares of a heavily shorted company called MagicJack (Nasdaq: CALL). The thesis Tilson laid out for being long MagicJack is quite compelling.

As of the most recent report, the number of shares that are currently short MagicJack stands at 29% of the company share count and 43% of the available float.

If even a moderate amount of these short sellers decide they want to exit their positions, it is going to create a tremendous amount of demand for MagicJack shares — which will likely drive the price up.

What MagicJack Does

MagicJack is a device into which any standard phone can be plugged and plugs in turn into a user’s computer (or, in the case of MagicJack Plus, plugs directly into a router). This allows the user to make unlimited phone calls to the United States and Canada.

To say MagicJack provides a big cost advantage to its customers is a huge understatement. The annual price for MagicJack is only $30, which is less than the monthly bill for most regular phone lines. That means that a family using MagicJack would save more than $300 over the course of a year by using it in place of a regular phone line.

With that kind of cost saving, converting to MagicJack a no-brainer for anyone who becomes aware of it. Not everyone is willing to go to the trouble of switching to save 5% — but to save 90%, wouldn’t just about everyone?

That no-brainer cost appeal is what makes being short shares of this company dangerous. MagicJack has huge growth potential just waiting to be realized.

In the United States there are currently 70 million homes that have a conventional telephone service or bundled (TV, Internet and phone) service. That is a huge number relative to MagicJack’s current subscriber base of only 3.3 million.

Every one of those 70 million homes could save huge dollars by converting to MagicJack. That means that this company could double or triple revenue and income and still just be scratching the surface of its potential. And that doesn’t factor in Americans living overseas who would love to have a home phone that operates as though they were in the United States.

Despite this huge growth potential, MagicJack’s shares trade at a very conservative valuation.

At a share price of $17, MagicJack has an enterprise value (market cap less net cash) of $250 million. For 2013, cash flow from operations is expected to be somewhere around $45 million. That means that MagicJack is trading at just over 5 times enterprise value to cash flow.

Five times cash flow is a pretty reasonable level, considering that MagicJack currently controls only 4% of a subscriber market to which it offers the no-brainer value proposition. Additionally, MagicJack has a pristine balance sheet that has $60 million in cash and no debt.  

What has been holding MagicJack back is less than stellar customer service. A new management team was recently bought in to rectify that problem.  

Once customer service has been brought up to speed, we can expect a very aggressive marketing campaign to start making consumers aware of the fact that they are spending 10 times more than they need to on their home phone lines. If people are made aware of MagicJack, chances are that they are going to switch to it.

If you are interested in buying shares, you may want to wait a few weeks. Tilson’s announcement of his interest in this company has created a pop in the share price that could subside once the hot money loses interest. The shares are still pretty attractively priced, but an even better entry price is likely.

MagicJack has huge growth potential, a reasonable valuation and a terrific balance sheet.  I think this is one time the short sellers have made a mistake.

Risks to Consider: Don’t get greedy and make this a large position. Short sellers are some of the savviest investors in the market. I think the short sellers are wrong in this case, but it is possible they know something about MagicJack that the rest of us don’t.

Action to Take –> Wait a few weeks and then consider buying a reasonable number of shares of MagicJack before the short squeeze starts. If a short squeeze ignites in the near term, look to take profits at $22, which would represent a fair valuation on current cash flow levels and rate of growth. If the short squeeze happens further out in the future, investors should also factor in whether earnings growth has accelerated from current rates.  A faster rate of earnings would merit a higher target price for taking profits.

P.S. If the potential of MagicJack has you excited, wait until you see what StreetAuthority’s Andy Obermueller has been working on. Andy has identified five “game-changing” trends with the potential to revolutionize the way we live our lives — and make early investors a killing. To learn more about these developing technologies — and the companies behind them — follow this link.