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 if their worry has some merit.

Company

Short Increase Oct. 15 to Oct. 31

Short Shares as a % of Float

PolyOne (NYSE: POL  )

63.5%

5.5%

Quantum (NYSE: QTM  )

56.4%

4.5%

Wells Fargo (NYSE: WFC  )

31.9%

0.7%

Source: The Wall Street Journal

Fizzling out?
Chemical adhesive companies may not be the most exciting by any means, but they can be surprisingly strong performers when the economy is on the mend. Shares of specialized polymer materials company PolyOne have been trickling progressively higher over the past few months, yet short-sellers appear to have honed in on what seems to be a higher trailing P/E than normal. Is this pessimism justified? I don't think so!

One of the primary reasons PolyOne is performing so well is its ability to innovate and improve its operating efficiency to make on-time deliveries of its products. In PolyOne's most recent quarter, it reported a record 27% increase in net income, despite a less than 1% rise in revenue. Another factor moving PolyOne shares higher is its $246 million offer to purchase thermoplastics maker Spartech (NYSE: SEH  ) , which will expand its product offerings for a reasonable 7.5 times Spartech's EBITDA. Finally, a strong rebound in domestic auto sales, with Ford (NYSE: F  ) and General Motors (NYSE: GM  ) showing unit sale gains of 5% and 4% year to date in 2012, and in the housing sector, have boosted domestic sales; enough, apparently, to more than cancel out the negative effects of Europe's sales slump.

PolyOne might seem expensive at 14 times forward earnings, but it's not a company I'd consider betting against even near a 52-week high.

Is success an encryption Quantum can figure out?
Quantum shareholders are used to the cyclical nature of its data encryption and storage solutions business -- but this time, some investors are wondering if Quantum actually has enough cash in the bank left to survive this latest downturn.

In Quantum's latest quarter, there were positive signs, including record disk system and software sales that allude to strong data center spending, but overall revenue dumped 11% as IT spending has been reined in by many companies -- especially overseas. What's more troublesome for Quantum looks like its growing debt load and shrinking cash balance. Quantum did announce a $60 million convertible debt offering to raise cash last month, but this seems like a short-term solution to a problem the company hasn't fixed just yet. I'm still moderately optimistic on Quantum on paper, but based on its tangible results, short-sellers appear to be firmly in charge.

Slow but steady wins the race
I'm not quite sure what short-sellers see in Wells Fargo, but I'm pretty sure I don't want anything that they've been drinking.

Wells Fargo definitely isn't the quickest growing big bank in the business, but it is, without question, one of the most fiscally prudent banks, choosing to grow by traditional banking practices rather than taking undue risks. In Wells Fargo's third-quarter report, the bank delivered a record profit of $4.9 billion despite a 25 basis point drop in net interest margin due to record-low lending rates. Short-sellers have been piling on Wells Fargo and its peers because of these record-low rates, but they've failed to take into account Wells Fargo's pristine portfolio, which is packed with high-quality loans that keep generating profits for the bank. Even Wells Fargo's chief financial officer, Tim Sloan, noted that his bank could have boosted margins by purchasing high-interest, high-probability of default, loans, but that wouldn't have been prudent.  

Wells Fargo may appear vulnerable if GDP growth continues to slow, but I think short-sellers would be foolish to make a long-term bet against this bank.

Foolish roundup
This week's theme is all about prudent management decisions. PolyOne and Wells Fargo's management teams believe in the slow-but-steady growth method while Quantum's results have been anything but consistent over time.

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.

Is Wells Fargo's high-quality loan portfolio enough to keep this bank growing, or will record-low interest cause Wells Fargo's growth to come to a halt? Get the answer to this question and much more by getting your copy of our latest premium research report on Wells Fargo. Packed with in-depth analysis on the opportunities and threats facing Wells Fargo -- and complete with a year of regular updates -- this report will give you the tools needed to make smart long-term investing decisions. Click here to learn more.


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