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 condemning 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.

Company

Short % Increase July 31 to Aug. 15

Short Shares as a % of Float

Knight Capital Group (NYSE: KCG  )

101.6%

13.9%

Ensco (NYSE: ESV  )

147.4%

3.7%

Limited Brands (NYSE: LTD  )

55%

4.1%

Source: The Wall Street Journal.

Gone in 45 minutes
It's been just over three weeks since a simple "Whoops!" almost bankrupted Knight Capital Group in a matter of 45 minutes. The market-maker, which handles more orders than any other routing company, failed to notice a trading glitch that allowed an older software program to kick in and radically amplified trading in 148 stocks. The impending loss to Knight turned out to be smaller than the initial estimates of $440 million, but it nonetheless wiped out $270 million in capital in less than an hour.

On the bright side for the company's long-term prospects, it was able to find financing that allowed it to stay solvent and retain its market-routing activities. Many of its former clients that had rerouted their orders elsewhere have returned to doing business with Knight, but the short-term costs of the deal were huge. Knight's share count will more than triple as the consortium of capital injectors can convert their preferred shares to common shares at just $1.50 per share.

Overall, much of the downside has been factored into Knight, but it will unquestionably face near-term scrutiny and could face even steeper losses as it liquidates its remaining positions. Over the long term Knight should be able to recover, but I wouldn't discount short-sellers being able to push this down further on even the slightest hint of bad news.

To drill or be drilled?
If you're wondering what Ensco did to draw the ire of short-sellers, then your guess is as good as mine. In late July, Ensco reported another stellar quarter that highlights the cost savings and added drilling diversification it's received from its purchase of Pride International last year.

For the quarter, Ensco grew total revenue by 90% while reporting a profit that easily eclipsed Wall Street's estimates. Deepwater revenue, which accounts for more than half of all revenue, rose 146% due to the Pride acquisition. More importantly, rig utilization rates spiked 500 basis points to 91% as dayrates increased 12.3%. These two key metrics mean that Ensco has very few idle rigs and that it's able to command top dollar for those being used. Jackup rigs were another source of strong growth as both utilization and dayrates had sizable increases.

With Noble (NYSE: NE  ) confirming Ensco's drilling strength with its second-quarter earnings report that highlighted a tripling in profits as drilling downtime decreased, along with the bankruptcy of ATP Oil & Gas, betting against Ensco, or practically any profitable offshore driller, seems like a bad idea.

Victoria's Secret? She has what consumers want!
For as long as I can remember, there's been a running joke as to what Victoria's Secret actually is. Well, I have an answer! The secret is that Limited Brands, the company behind Victoria's Secret, has the product mix that consumers want. (Wasn't that simple?) Limited Brands in July reported a 12% increase in same-store sales for Victoria's Secret – the 31st consecutive month that same-store sales for the chain have exceeded 7%!

What we're seeing from Limited Brands and one of its intimate apparel rivals, Hanesbrands (NYSE: HBI  ) , is that there's little pricing pressure in discretionary intimate purchases at the moment. Even with cotton prices providing a drag, Hanesbrands skirted past Wall Street's projections in its most recent quarter. That's a formula that bodes well for both companies over the near-term.

In addition to its intimate apparel success, Limited Brands also witnessed growth of 17% from Bath & Body Works in July. If Limited can keep these growth figures up, short-sellers would be akin to challenging an oncoming train by standing in the middle of the railroad tracks.

Foolish roundup
This week's theme revolves around the idea that just because a stock is up, it doesn't mean it couldn't head higher. Ensco and Limited Brands aren't the values they were a few months ago by any means, but their earnings results signal continued strength. Even an underperformer like Knight stands to claw its way back if it can get through the next few months, glitch-free!

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

And if you'd like to avoid the potential pitfalls that high short interest can bring, I suggest you download a copy of our 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!

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of Ensco and Costco. Motley Fool newsletter services have recommended buying shares of Costco. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that never needs to be sold short.


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