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 Nov. 30 to Dec. 14

Short Shares as a % of Float

Annaly Capital Management (NYSE: NLY  )

45.4%

3.6%

Limited Brands (NYSE: LB  )

31.1%

3.7%

Herbalife (NYSE: HLF  )

26.5%

24.7%

Source: The Wall Street Journal .

The divid-end?
If you took a closer look at the mortgage-real estate investment trust, or mREIT, sector at the moment, you'd think the perfect storm is brewing. Low lending rates and a very accommodative monetary policy implemented by the Federal Reserve, which has the agency purchasing $40 billion in mortgage-backed securities and $45 billion in U.S. Treasuries monthly, continue to shrink the net interest margin of many mREITs, including Annaly Capital and its closest big peer, American Capital Agency (NASDAQ: AGNC  ) . The question is: Should shorts pile on in anticipation of a dividend cut?

While I'm inclined to say that over the very short term, short-sellers could get lucky enough to eke out a gain, over the long term, Annaly's and American Capital's ability to lever their portfolios to take advantage of what is a very visible lending market (we know the Federal Reserve has no plans to change its stance on lending rates until unemployment hits 6.5%), and to rely on the fact that all of their MBS's are backed by the full faith of the U.S. government in case of default, is too strong of an agent to side with short-sellers. At no point over the past decade has Annaly's annual yield dipped below 4%, and, as one of the oldest names in the business, its management understands how to best position the company to adapt for changing monetary climates. I would be shocked to see Annaly's yield dip below 8% any time before 2015.

Want to know the secret?
Honestly, the secret has been out of the bag for a long time for Limited Brands, the owner of Victoria's Secret and Bath & Body Works: Give the customers what they want! It's an amazing concept, but Limited's ability to correctly anticipate what customers want on the shelves and to manage inventory levels with amazing precision has allowed it to reduce its discounting to a minimum and push high-margin intimate apparel and accessory items off its shelves.

In early November, Limited "disappointed" the Street by reporting same-store sales growth at Victoria's Secret of just 3% -- breaking a streak of 30-plus months of 7% growth. However, even with the same-store sales miss, Limited boosted its earnings guidance significantly higher than analysts' expectations. Investors really shouldn't be that surprised that same-store sales growth tapered considering the tough year-over-year comparisons. Relative to its peers, though, Limited continues to click on all cylinders. As we head over (or near) the fiscal cliff, this is one of the few retailers positioned to excel.

Ack-man! I've been Einhorned!
It's never a good thing when your company attracts one of the most noted short-sellers on Wall Street; it's even worse when the short-sellers start to gang up on you. That's the case for nutritional supplement company Herbalife, which has drawn the ire of both Bill Ackman and David Einhorn as a potential "fraud." Although Herbalife's CEO, Michael Johnson, has vehemently denied any allegations against his company, Herbalife's share price has paid the price. In addition, it's brought down shares of Nu Skin Enterprises (NYSE: NUS  ) which dealt with its own allegations of running a multilevel marketing scheme out of China, according to research from short-selling specialist Citron Research in August. 

The big question is: What comes next? I believe that will be answered during the next Herbalife conference call, when it'll be up to Michael Johnson to lay out the case for why Ackman and Einhorn have pigeonholed his company into something that it isn't. What I'd be more interested in is Johnson's long-term vision to keep both employees and customers loyal to the brand. Brand and company loyalty is rare among nutritional supplement and fitness providers and is one reason I tend to avoid this sector at all costs.

Foolish roundup
This week's theme entails whether or not history is on your side. Both Annaly Capital and Limited Brands have management teams that I feel confident about; Herbalife's CEO doesn't exactly inspire that type of confidence, nor does the company's business model.

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.

More expert advice from The Motley Fool
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Comments from our Foolish Readers

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 January 01, 2013, at 11:16 AM, rsinj wrote:

    In this situation, I'm really not interested in what the CEO has to say. Is there any question that he'll get up and deny the allegations and do whatever damage control he can?

    For anyone who has taken the time to go through Ackman's 300+ slide presentation (it's online for everyone to see), it's obvious he's done a lot of work, and laid everything out in very easy and straightforward terms that everyone can understand. Ackman's done all the work, and now it's time for the FTC to step in, take what he's done, and make a final ruling/statement regarding the situation. Ackman's made a "citizen's arrest" now the legal authorities need to decide. Do you think the perpetrators will say anything less than "We're innocent, you're wrong"?

    Everyone already knows what Johnson will say. We need a final statement from the FTC that HLF is or is not a pyramid scheme. If it is, then shut it down immediately.

    If it looks like a duck and quacks like a duck...

  • Report this Comment On January 02, 2013, at 3:08 PM, plange01 wrote:

    time for the shorts to worry!the new budget is great news for dividend investors tax rates remain at 15% on income up to $400,000

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