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 number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Company

Short Increase Feb. 28 to March 15

Short Shares as a % of Float

Allstate (NYSE: ALL  )

151.3%

3%

Stryker (NYSE: SYK  )

53.8%

2.7%

Sunoco Logistics Partners  (NYSE: SXL  )

61.5%

1.3%

Source: The Wall Street Journal.

In good hands
It isn't hard to understand why short-sellers have piled into property, casualty, and life insurer Allstate in recent weeks: Its share price has doubled over the past 16 months, which is no easy feat for an insurance company. It's even more impressive if you consider that this amazing run comes after two catastrophic events in back-to-back years -- the tornado outbreaks of 2011 and Hurricane Sandy of 2012. In spite of this huge run, I'm still convinced that short-sellers are barking up the wrong tree by betting against Allstate.

In the fourth quarter, Allstate investors witnessed profits tumbling 45% as the company's property-liability combined ratio (a measure of how profitable it is to underwrite policies) rose to 101.7% from 90.9% in the year earlier -- a figure under 100% would signify profitable underwriting. This was a direct response to a spike in claims related to Sandy, but it wasn't out of the ordinary from the figures we've seen with Allstate peers. P&C insurer Chubb, for instance, really took it on the chin with a loss of nearly $900 million from Hurricane Sandy, which wiped off about $2 in EPS from its bottom line. 

Even including the effects of Hurricane Sandy, property-liability net premiums rose 3.3% to $6.64 billion, which was well ahead of estimates. What this shows me is that Allstate is luring in new customers with its somewhat aggressive advertising campaign, and it's easily able to boost premium pricing. The interesting thing about catastrophe losses is that they're often short-lived as they give insurers a justifiable reason to boost premiums. At less than 10 times forward earnings, Allstate is not a company I'd dare consider betting against.

Consider yourself warned
Make no mistake about it: I'm a medical devices bull. A growing population of aging Americans coupled with an expansion of our health care system due to the passing of the Patient Protection and Affordable Care Act in 2010 appears to be playing into the hands of further device usage. However, that doesn't mean that all medical device makers are automatically buys.

Stryker, for example, isn't going to win any compassion awards from the American public after announcing the layoff of 5% of its workforce last year in direct response to the medical device excise tax, which takes a 2.3% tax off total revenue to help pay for the Medicaid expansion under the PPACA. Stryker isn't alone, with NuVasive CEO Alexis Lukianov threatening to move his operations overseas because of the medical device tax.

There are other warning signs that should have investors concerned about Stryker's immediate growth prospects. To begin with, Stryker was forced to take a $133 million charge in the fourth quarter related to a recall of its Rejuvenate and ABG II product-line hip implants in June. The company halted worldwide distribution on concerns that fretting and corrosion of the implants could cause an adverse tissue reaction or (even worse) pain for patients.

More recently, Stryker received a warning letter from the Food and Drug Administration following an inspection at a facility in Michigan. The letter addressed concerns about Stryker's marketing of the Neptune Waste Management system despite not having a government-sponsored approval for the device, and for not notifying the FDA regarding a product recall.

These variables are more than enough to cause an investor in Stryker to become concerned, and should be enough for short-sellers to latch onto considering that revenue growth is only in the 4% to 5% range.

Oil is thicker than short-sellers
For all intents and purposes, any company that doubles in less than a year is often going to draw the ire of short-sellers. Even I'm taken back by the amazing run that midstream master-limited partnership Sunoco Logistics Partners has given shareholders since the beginning of June -- a rise from $32 to better than $65. Yet, as with Allstate, even a big run like this isn't enough to scare me away and should serve to keep short-sellers on a short leash.

Sunoco Logistics might be a bit pricey at 20 times forward earnings, but it underscores the amazing opportunity that lies ahead for transportation, storage, and terminal facilities given the sheer volume of natural gas, liquid natural gas, and oil deposits discovered in the mainland U.S. over the past decade. Over the next 10 years, I feel no aspect of the oil and gas industry is bound to see more rapid growth than the infrastructure being developed to transport and store the vast amounts of these new deposits. That would also be consistent with President Obama's push toward U.S. energy independence, which will rely on unlocking our vast amounts of natural gas reserves.

Another often overlooked aspect here is Sunoco Logistics' understated 3.3% yield, which has been raised for a staggering 31 consecutive quarters. Why a short-seller would bet against that type of consistency is beyond me!

Foolish roundup
It's a mixed bag this week, with Allstate and Sunoco Logistics both looking like they have plenty of room to move higher despite having doubled in price. As for Stryker, while I like the long-term potential for medical device makers, a recent rash of recalls, warning letters, and layoffs portends possible growth concerns and enough reason for short-sellers to take a stand.

What's your take on these three stocks? Do short-sellers have these stocks pegged, or are they blowing smoke? Share your thoughts in the comments section below.

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