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% of stocks -- nearly two-thirds -- 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 look at three companies that have seen a rapid increase in the amount of shares sold short and see whether traders are blowing smoke or whether their worry has some merit.

Source: The Wall Street Journal.

Don't confuse generic with ordinary
I've said it before and it bears repeating again: There's nothing ordinary about generic-drug makers.

Teva Pharmaceutical and its generic-drug peers benefit from an endless supply of big pharma innovation that only has a finite lifespan on patent protection. What this means for generic manufacturers is a steady stream of new generic-drug candidates. Also, the costs associated with producing a drug are much lower for generic companies since they don't need to spend anywhere near the amount of time and money that initial drug developers do. These minuscule costs are translated into a significantly lower price point for the generic product as opposed to the branded drug, saving patients money and putting hefty profits in generic-drug producers' pockets.

Teva is a rare breed in that it also is a front-line innovator and holds patents until 2014 on the best-selling multiple sclerosis drug Copaxone, which it expects will bring in $3.8 billion in revenue this year. However, recent data from Biogen Idec (Nasdaq: BIIB) suggests that its experimental oral MS drug, BG-12, has been more effective than Copaxone. There are also concerns that Teva's sales will take quite a tumble when Copaxone goes off patent in two years. To remedy this, Teva has been testing a more concentrated form of the drug. If it can get this new version approved, the fear of losing patent exclusivity will soon be alleviated, and short-sellers may be left holding a losing investment.

Is an about-face likely for this company?
As an avid watch enthusiast, I make sure, as best I can, to keep abreast on the latest news within the Swiss watch industry. Based on the latest report from the Federation of the Swiss Watch Industry, wristwatch shipments were up 3.3% in the first four months of the year while export values rose 15.2%. That, simply put, means watch companies have the pricing power and demand to get more bang for their product.

Movado Group's latest quarterly results signal this trend in action. For the recently ended quarter, Movado reported a 15.4% increase in sales and forecast strong growth for the remainder of the year. We've seen similar strength recently from apparel, watch, and accessory maker Michael Kors (NYSE: KORS), which blew expectations out of the water last week with companywide same-store sales growth of 36.1% and wholesale net sales up 45.5%.

The point here is that watchmakers have significant pricing power at the moment and demand remains strong -- that's not a combination I'd consider betting against.

Putting the puzzle together
Wise investors have said that diversification is the key to surviving market meltdowns. However, in Eaton's case, the maker of everything from truck and automation systems to hydraulics and pneumatic systems for commercial and military use may be barking up the wrong tree -- at least for now.

Eaton's path to growth of late has been through acquisitions. Eaton recently announced it was buying Cooper Industries and has been making smaller strategic buys that will open it up to growth in the emerging markets of Europe, the Middle East, and Africa, as well as certain parts of the Asia-Pacific region. Although I applaud Eaton for its growth initiative, I see two problems that could derail its near-term prospects and put a smile on short-sellers' faces.

First, Eaton's business is highly dependent on global growth. With questions surrounding Europe's prospects and China's growth slowing, an industrial parts provider like Eaton probably won't fare very well. Second, it takes time for a company to gel all of its acquisitions together. Eaton's binge-buying spree may be a long-term solution to product diversification, but it looks like a near-term logistical nightmare that I suspect will be wrought with operations hiccups.

Foolish roundup
This week we simply looked at long-term industry trends and allowed those to guide our analysis. Generic-drug makers and watchmakers have exhibited strong growth for years and you'd have to be pretty lucky to correctly call an end to their growth cycle now. Eaton, on the other hand, is at the mercy of a fickle global economy that's showing little signs of being healthy.

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 using the links below to add these stocks to your free and personalized watchlist and keep up on the latest news with each company.

Also, if you'd like to avoid the potential pitfalls that high short interest can bring, I suggest you download a copy of our latest special report: "The Motley Fool's Top Stock for 2012." In it, our chief investment officer gives you the skinny on a company he has dubbed the "Costco of Latin America." Best of all, this report is completely free, but only for a limited time. Don't miss out!

• Add Teva Pharmaceutical to My Watchlist.
• Add Movado Group to My Watchlist.
• Add Eaton to My Watchlist.