In the past, academic research has shown that stocks with high levels of short interest are connected with a high probability of experiencing negative abnormal returns subsequently. Therefore, the common sense implies that it should be possible to gain an advantage of the aforementioned stocks. The theory says that shorting stocks with all the constrain (connected with the shorting) is most often made by the informed investors whose activity ultimately helps prices incorporate more information. Moreover, the level of their holdings has predictive power about returns and fundamentals of the stocks. Knowing the short-interest can lead to a strategy that consists of simply joining informed short-sellers. The long-short variation (our screener also includes the long-only variant) of this strategy would be performed by the shorting stocks with high short interest and going long stocks with low short interest.
Overall, the academic world support this anomaly, for example, Asquith, Pathak, and Ritter in their work “Short Interest, Institutional Ownership, and Stock Returns“, say that “Stocks are short sale constrained when there is a strong demand to sell short and a limited supply of shares to borrow. Using data on both short interest, a proxy for demand, and institutional ownership, a proxy for supply, we find that constrained stocks underperform during 1988-2002 by a significant 215 basis points per month on an EW basis, although by only an insignificant 39 basis points per month on a VW basis. For the overwhelming majority of stocks, short interest and institutional ownership levels make short-selling constraints unlikely.” Additionally, the authors of this paper state that: “The cross-sectional relation between short interest and future stock returns vanishes when controlling for short-sellers’ information about future fundamental news. Thus, short-sellers contribute, in a significant manner, to price discovery about firm fundamentals.” Last but not least, this long-short strategy has a low correlation to the overall market, and therefore, the strategy can be used as a portfolio diversifier.

The literature offers two popular explanations for this predictability, namely the overvaluation hypothesis and the information hypothesis. The first possible explanation for the short interest effect – the overvaluation hypothesis stems from the work of Miller (1977). His theory says that stocks with high levels of short interest are overvalued because pessimistic investors are unable to establish short positions, leaving only the optimists to participate in the pricing process. In this model, market forces are unable to prevent overpricing in the amount of shorting costs when these costs are high. The greater the shorting costs, the greater the possible overpricing, and therefore, the lower the subsequent stock returns.
The second and probably more valid explanation is the information hypothesis. The information hypothesis builds on a broadening base of empirical research that demonstrates that short sellers are well-informed traders. Those mentioned above could be the reason for the functionality because if one follows the decisions of the short-sale practitioners, who tend to be investors with superior analytical skills (for example, according to the research of Gutfleish and Atzil, 2004). The main idea is simple; the research says, that these investors typically initiate short positions only if they can infer low fundamental valuation from public sources. For example, short-sellers may engage in forensic accounting, looking for high levels of accrual as evidence of hidden bad news. Still, there is a large number of other possibilities than just accruals.