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 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 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 Sept. 14 to Sept. 28

Short Shares as a % of Float

CVS Caremark (NYSE: CVS  )

78.8%

1.9%

LSI (NYSE: LSI  )

35%

2.8%

American Eagle Outfitters  (NYSE: AEO  )

57%

8%

Source: The Wall Street Journal

Pile on
Short-sellers have shown no mercy with regard to CVS Caremark lately, piling on an additional 10.4 million shares sold short than they held over the prior two-week period. What could cause such negativity? I'd say investors are taking weakness from Rite Aid (NYSE: RAD  ) as a cue to be concerned.

In September, Rite Aid reported a comparable-store sales decline of 0.7%, with pharmacy sales providing the biggest drag, down 2.3%. Greater generic-drug competition as well as a mending of a spat between Walgreen (NYSE: WAG  ) and Express Scripts appears to have investors concerned about whether CVS' pharmacy business can track higher and whether it can hold on to the customers it gained from Walgreen earlier this year.

I believe the mistake the investing community is making here is in trying to correlate the results at Rite Aid in any way to those of CVS. Rite Aid is a highly indebted disaster and CVS' results have in no way indicated a slowdown, nor has management suggested that it wouldn't be able to hold on to its pharmacy gains from the Walgreen-Express Scripts spat. Walgreen offers the premium dividend of this group, but there's no immediate reason I see to be pessimistic about CVS' outlook. Short-sellers, you've been warned!

Chip off the old block
Sometimes it's best to look at a company's industry peers for clues as to where it could be headed next. If that statement holds true, LSI shareholders may want to brace themselves for the third-quarter release due out this Wednesday.

The maker of specialized storage and networking semiconductor chips and its peers have suffered through weak spending, fluctuating demand, and weak pricing environments that have brought down estimates across wide swaths of the semiconductor sector -- not just those related to storage and networking. It's a company that makes a lot of sense on paper over the long-term as storage demand due to the build-out of big data centers is only bound to increase, but recent weakness from peer Marvell Technology might signal investors to temper those expectations.

Although LSI is getting more attractively valued, short-sellers could rule the roost in the near-term.

Back to school or getting schooled?
The retail sector is admittedly a tough nut to crack as fashions change with each passing season, consumer spending habits fluctuate sometimes without reason, and retailers have a hard time controlling inventory levels, which occasionally leads to margin-killing discounts. Luckily for American Eagle, it makes up for it with impressive dividends and has a long history of increasing shareholder value.

The impetus for short-sellers to be skeptical is there; both Aeropostale and Kohl's, which sell similar fashions to American Eagle, have struggled to maintain their margins due to excessive discounting, and consumer spending is down, which would lead many to believe American Eagle could be in for a rough quarter. However, it's worth noting that American Eagle has either met or beat Wall Street's estimates in each of the past four quarters and will normally pre-announce if it's going to miss estimates. With that not happening thus far, I can only assume that the company's fashion trends are still running strong with America's teen population, and that it'll turn in another stellar quarter. Needless to say, I wouldn't want to be on the short side of this trade.

Foolish roundup
This week's theme is all about the earnings. Examining a company's ability to meet earnings as well as the earnings quality of its peers can often tell you a lot about where it could be headed. American Eagle and CVS appear to be chugging along just fine, while LSI could be in for a tough quarter.

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.

As I opined above, the retail sector is a tough one to predict. Luckily for you, our analysts have handpicked three stocks to rule the retail sector over the long-term. Click here to get your copy of this latest special report, for free, and find out the identity of these top picks and the reasoning behind them.

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.

Motley Fool newsletter services have recommended buying shares of Express Scripts. 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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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 23, 2012, at 1:00 AM, tomd728 wrote:

    Short sellers get caught in the wrong stock at the wrong time and probably more than the believers in LTBH.....

    The shorting of CVS by these guys is already in the stock price and I don't see any events on the horizon

    that beckons a sell-off.

    I'm all ears on a different take on CVS as I am long and never really enjoyed the effect of "long & wrong"

    Thanks,

    Tom Durkin

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