Root Looks Primed for a Short Squeeze: Is the Stock a Buy? - Motley Fool

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Root (NASDAQ:ROOT) is attempting to disrupt the auto insurance industry with a novel approach based on real-time driver data. So far, Wall Street isn't impressed. The stock is down 56% since its initial public offering in October, and it's one of the most heavily shorted stocks on the market.

This has created an interesting situation. Certain insiders can't sell shares until April 26, and based on the heavy short interest, Wall Street is expecting a lot of selling. But if that never materializes, this situation could spark a short squeeze -- a market dynamic where a rising stock price forces short-sellers to close their positions by buying shares, sending the price up even more.

Here's what you should know.

Image source: Getty Images

The auto insurance market

Traditionally, insurance providers have priced policies using pooled risk assessment, meaning they group "similar" individuals together (based on criteria like age, vehicle, location, and driving history) and charge everyone in a group the same rate.

Newcomer Root is using technology to price policies on a more individualized basis. Specifically, it uses smartphone sensors to collect data through its mobile app -- information like how sharply the driver brakes, how quickly the driver takes turns, and how consistently the driver follows the same routes.

The company uses machine learning and statistical analysis to transform that data into behavioral scores. This allows Root to more precisely quantify risk. To that end, the company has elected not to insure the riskiest 10% to 15% of drivers. But for everyone else, Root is able to price policies in a more personalized way, offering lower prices for safer drivers. That should help it attract and retain lower-risk clients.

In addition to offering auto insurance in 30 states, Root also earns revenue by underwriting renters policies in nine states, and by selling homeowners policies on behalf of Homesite Insurance in 18 states.

That puts Root in front of a big market opportunity. The U.S. auto insurance market alone is worth $266 billion annually, according to management. And the more recent additions of renters and homeowners products only make its opportunity bigger.

Root's financial performance

Root's business is gaining traction with consumers. In 2020, auto policies in force jumped 15%, and renters policies surged 343%. At the same time, premiums per policy grew by 4% for auto policies and 10% for renters policies. In other words, Root is adding new customers at a good pace, and generating more revenue per customer.

That translated into relatively strong top-line growth last year.

Metric	2019	2020	Change
Revenue	$290 million	$347 million	20%

Source: Root SEC Filings.

Notably, the company's loss ratio -- the percentage of earned premiums spent on claims and adjustment expenses -- has dropped from 111.9% in 2019 to 92.1% in 2020. That's a good sign, but investors will need to pay careful attention to this metric going forward. Many people have been driving a lot less than usual during the pandemic, which almost certainly helped bring Root's loss ratio down last year.

And even at 92.1%, the company's loss ratio is well above that of its rivals. For instance, Allstate posted a loss ratio of 57.5% for its auto insurance business last year. That means Root still has a lot to prove.

As a final caveat, Root is currently unprofitable. This is primarily due to high loss-related expenses, though the company is also spending heavily on sales and marketing. As a result, cash from operations dropped to a loss of $287 million in 2020.

A final word

Root has an interesting business model. By trying to eliminate bias and price policies more fairly, the company should be able to attract and retain customers. Likewise, by reducing its exposure to risk, Root may eventually become more profitable than traditional insurers. But right now, it's a small company competing against much larger and more profitable rivals.

I do think Root has long-term potential. But for anyone considering buying shares, let me offer two pieces of advice: First, Root's business model is largely untested, meaning things may not work out. That's why investors should start with small positions -- don't go all-in on this stock.

Second, don't buy this stock expecting to see a short squeeze in the near future. That's risky. If you choose to invest in Root, make sure it's because you believe in the company's long-term prospects.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Root Looks Primed for a Short Squeeze: Is the Stock a Buy? - Motley Fool
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