7 Stocks Under Attack

Since everyone loves a winner, it's reasonable to assume that everyone hates a loser -- everyone but short sellers, at least. These contrarian investors bet that hot stocks are primed to fall, aiming to turn their pessimism into potential profits.

This week, let's look at companies on the Nasdaq exchange with the biggest increase in shares short. We'll then consult the collective intelligence of Motley Fool CAPS to see which of these firms Fools believe have the power to make short work of short sellers.

Of course, this isn't a list of stocks to buy -- or short! These stocks could have serious problems that warrant their short interest, but they might also be stricken by short-term troubles. Only Foolish due diligence will tell you for certain; our 83,000-strong CAPS community just offers a good place to start.

Most of these companies are generally well-liked; they've garnered three stars or better on their CAPS ratings. Yet Solarfun, as the lone company on the list which has managed to enjoy a positive return over the past year, has also seen the shorts line up against it this month with a whopping 20% of its shares sold short.

What a pain
Not surprisingly, shares in the alternative energy firm have dropped by more than 45% since the start of the year and by a quarter alone in the two-week time span during which the shorts began piling in. As of yesterday's close, they had regained about 11% of their value. So is Solarfun about to become fun again and rout the shorts? Perhaps not.

Part of the drag on Solarfun's share price (aside from the general malaise of the entire industry; solar stocks are off 20% or more since the start of the year) seems to be a $150 million convertible debt offering the company priced at $19.13 per share near the end of last month. At the same time, another 7.8 million shares were lent to Morgan Stanley for it to sell to the bond investors to hedge their positions. Due to the nature of convertible bonds, the invitation to short the stock becomes more enticing. Let me explain.

Convertible bondholders earn interest on the bonds as long as they hold them. If the stock goes above the $19.13 price, they could convert the bonds into shares and sell them, making a profit. On the other hand, the bondholder risks losing money upon conversion if the share price drops, especially if conversion is mandatory at maturity. To hedge against this or against default risk, many of them short the shares -- that's where that loan of shares to Morgan Stanley comes in. Bondholders can view the shorting as a relatively risk-free hedge play.

The downside to owners of the common stock is that they bear the brunt of things both ways. If the price goes up and the bonds are converted, shareholders get diluted. Meanwhile, more shorting of the shares can occur, potentially putting downward pressure on the price in the near term.

Meanwhile, over on CAPS, top-rated All-Star NeroSagetrade, with a 89.53 player rating, sees the forecasted sales and earnings growth potential as offsetting any short-term issues for the company. This is his pitch from early last month (before the convertible bond issue arose):

Solarfun is producing huge contracts and is set to grow revenues at over 230% this year and 101% next year. They have seen their earnings estimates rise so dramatically most analysts are having issues keeping up with them. How does 4 times forward [earnings estimates] sound? Just crazy with triple digit revenue growth.

Speak up
You've heard from CAPS investors -- now it's your turn to have your say. Share your views with the CAPS community: Squeeze 'em till it hurts, or short 'em till the sun don't shine? May the best argument prevail!