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.


Short % Increase, July 31 to Aug. 15

Short Shares as a % of Float

SolarWinds (NYSE: SWI  ) 73.7% 4.2%
Burger King (NYSE: BKW  ) 70% 2.3%
LeapFrog Enterprises (NYSE: LF  ) 68.2% 8.9%

Source: The Wall Street Journal.

A TMFULOI breaker?
For those of you not familiar, roughly four months ago I developed my very own overvaluation index known as the TMFUltraLong Overvaluation Index, or TMFULOI -- which, up until now, has been a very good indicator of companies poised to head lower. You can see for yourself how my index works, but also understand that it isn't without its flaws. As my colleague Rick Munarriz pointed out, it completely discounts rapid growth rates -- and IT-management software company SolarWinds looks as if it could be the first company to really "beat" my index.

For the second quarter, SolarWinds reported a 39.7% increase in sales and just a 31.4% increase in expense, as license and maintenance revenue both jumped an eerily similar 39.7%! More importantly, net income rose 51% while net margin increased 260 basis points.

Still, I remain steadfast in my original assessment that SolarWinds is grossly overvalued. Based on the median point of the company's upcoming growth forecast of 22% to 27%, that places the company at a PEG ratio of 1.5, with a price-to-cash-flow of nearly 32. With growth rates slowing, who's going to pony up 37 times forward earnings for this stock? Not this guy, that's for sure!

A crown of thorns
If I had it my way, Burger King would be doing a lot better than it is now. Since being taken private by 3G Capital Partners and re-emerging as a publicly traded company, Burger King has managed to lose its No. 2 spot in burger sales to Wendy's and has fallen even further behind all of its peers in the United States. Burger King had been focusing on expanding its international base but somehow forgot that the majority of its sales come from the U.S. -- go figure!

The company is attempting to play copycat by using some of the healthful-food trends and menu additions that McDonald's (NYSE: MCD  ) has used to move nutrition-hungry consumers through its doors, but it's light-years behind everyone else. Also on the menu is a fresh look for many of its stores. A freshening up of its storefront worked wonders for McDonald's and has turned Jack in the Box's numbers around, but I have to wonder whether there's any room for market-share gains from Burger King. Where's the differentiation and the motivation to head to Burger King? By the look of things, I'd say the shorts are having it their way!

Kid-tested, techie-approved
Who said Apple (Nasdaq: AAPL  ) was the only company set to corner the tablet market? LeapFrog Enterprises, in its most recent quarter, reported a 153% increase in multimedia sales (i.e., its kid-geared tablet known as the LeapPad), with total sales of all products in the U.S. nearly doubling. This growth seems unlikely to wane anytime soon, with LeapFrog's tablet price of $100 undercutting basically all of its tablet peers, and parents being completely willing to pony up the cash to educate their children.

As I highlighted in July, when I proclaimed that LeapFrog's run might just be beginning, it won't be without its own set of challenges. One of LeapFrog's key strategies is to develop an app-based system on its LeapPads geared toward kids -- a move very similar to how Apple has built its app-based empire. LeapFrog CEO John Barbour did note, however, that direct competition from Google's Android operating system could thwart its plans.

If LeapFrog can execute on its long-term goals and continue to push its LeapPad -- which, in turn, should remove the cyclicality of its business -- then short-sellers could be standing on the wrong side of the tracks when all is said and done.

Foolish roundup
This week's trend is, well, trends! SolarWinds is growing rapidly, but that growth trend is poised to slow over the coming years while Burger King's U.S. sales have been on a multiyear decline. LeapFrog, on the other hand, has seen sales of its LeapPad explode. These trends, at least to me, dictate how short-sellers should be reacting to these companies.

Does the LeapPad really present a threat to the Apple iPad? Is the launch of the iPhone 5 going to be as epic as everyone predicts? Find out the answer to this question, and much more, by getting your copy of our latest premium research report on Apple. This report highlights the opportunities and pitfalls that could move Apple's share price and comes complete with one year of regular updates. Claim your investing edge and get this report.

What's your take on these three stocks? Do the short-sellers have them pegged, or are they blowing smoke? Share your thoughts in the comments section, and consider using the following links to add these stocks to your free and personalized Watchlist to keep up on the latest news with each company.

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 McDonald's and Apple. Motley Fool newsletter services have recommended buying shares of McDonald's, LeapFrog Enterprises, Apple, and Google, as well as creating a bull call spread position in Apple. 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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  • Report this Comment On September 06, 2012, at 11:46 AM, GarySetiadi wrote:

    I am from Malaysia. McDonald's is really popular here and always crowded. Lately, I have noticed that Burger King is getting popular here as well. BK is a welcome alternative and I find their burgers tastier than McD. Their menu is slightly more expensive than McD but is much better than CarlJr which is expensive and doesn't taste good in my opinion.

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Sean Williams

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest.

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