Shorts Are Piling Into These Stocks. Should You Be Worried?

The best thing about the stock market is that you can make money in either direction. Historically, stock indexes have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty of stocks that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% (nearly two-thirds) of stocks underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a damning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's take a look at three companies that have seen a rapid increase in the amount of shares currently sold short and see if traders are blowing smoke or if their worry could have some merit.

Source: The Wall Street Journal. NA = not available.

H2...Whoa!
I'm not shy about my love for certain water utility stocks. Water is an incredibly underappreciated resource, and with the world's population growing as rapidly as it is, water is going to become an increasingly valuable resource. It's for this reason that the rapid rise in shares held by short-sellers of Xylem makes little sense.

Xylem is at the forefront of water usage -- its technology enables public utilities to transport, treat, test, and efficiently use water. The primary knock against the company is simply that it's a recent IPO and thus untested in the earnings arena. Well, fear no longer, because Xylem's third quarter looks perfectly healthy to me. The company's pro forma profit of $0.55 crushed the handful of estimates given, while organic growth of 6% appears strong for a company its size. Most important, new orders were up by 19%. Based on its current dividend yield of 1.7% and at 12 times forward earnings, you could do much worse in the water sector.

Don't touch that lever-age
Given the recent collapse at MF Global, Jefferies Group finds itself in a precarious position. On one side are the pessimists who see Jefferies as an over-levered financial institution similar to Lehman Brothers and MF Global. At least one analyst has said that Jefferies should raise $1 billion in additional capital to decrease its leverage. On the other hand, optimists feel that Jefferies Group is a conservatively run institution that is well capitalized and valued well below book value. Reality probably lies somewhere in between these arguments.

What I can tell you is that Jefferies, much like Bank of America (NYSE: BAC) and Morgan Stanley (NYSE: MS), has drawn the ire of short-sellers, and that's rarely a good thing. In the "shoot first and ask questions later" mentality that is pervading the financial sector at present, I'm more apt to take a wait-and-see approach with Jefferies and let its earnings reports do the talking.

Sell phone
Watching Nokia attempt to compete with Apple (Nasdaq: AAPL), Samsung, and HTC in smartphones is like pouring salt on a snail and waiting for the inevitable result. Nokia has been losing market share hand over fist recently, and that trend seems unlikely to reverse anytime soon. The worst part is that short-sellers know this all too well.

Since Oct. 31, short-sellers have increased their positions on Nokia by 16%. One good reason for this has to do with Nokia's steadily declining gross margins. As the company has been finding success only in lower margin phones, Nokia shareholders have witnessed a decline from nearly 36% in mid-2008 to less than 30% in the trailing-12-month period. With revenue growth looking stagnant at best, I'm certainly not willing to pony up my hard-earned money for Nokia shares, and I wholeheartedly agree with the shorts here.

Foolish roundup
There's a big difference between betting against a necessary item like water and a luxury item like a smartphone. Choosing wisely could mean the difference between a hefty profit and a pounding headache.

What's your take on these three stocks? Do the short-sellers have these stocks pegged or are they blowing smoke? Share your thoughts in the comments section below and consider adding Xylem, Jefferies Group, and Nokia to your free and personalized watchlist to keep up on the latest news with each company.