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 April 15 to April 30

Short Shares as a % of Float

Lear (NYSE: LEA  )

1,042.2%

13.7%

Corrections Corp. of America (NYSE: CXW  )

88.3%

7.2%

Select Medical (NYSE: SEM  )

65.1%

4.6%

Source: The Wall Street Journal.

Are short-sellers "parking" their money in a bad place?
Lear, a manufacturer of car seats as well as other electrical components for autos, has certainly drawn its fair share of naysayers over the past couple of weeks. Delayed tax refunds at home and weakness in European markets cued many investors into thinking Lear could be headed for a slowdown. However, Lear's first-quarter results demonstrated otherwise.

In the quarter, net income did fall 19% because of weak demand in Europe and higher costs in South America, but a big rise in Chinese demand led to the company's 14th straight quarter of sequential margin expansion, and a top- and bottom-line beat of Wall Street's expectations. Furthermore, Lear set an $800 million share repurchase program and boosted its dividend by 21% to $0.17 per quarter. I highly doubt we'd see such aggressive value-building tactics had Lear felt a contraction was around the corner.

Although the results were strong (all things considered), I do think that Lear shareholders should temper their expectations moving forward. Even with the company valued at just nine times forward earnings, U.S. auto sales growth this year could be the slowest we've seen since the recession. Results from Ford in April may have spoofed that notion as F-Series trucks saw a 24% increase in units sold while car and light truck volume rose by 18%. But it's hard to argue against the overwhelmingly negative effects we've witnessed so far from higher payroll taxes and delayed tax refunds throughout the retail sector.

Who said crime doesn't pay?
Necessity businesses are often great investments because there's usually safety in their cash flow. Water and electric utilities, as well as trash collection, are examples of businesses that take care of life's essentials. I'd propose that we should also add jailing a growing population of prisoners as yet another of life's necessities.

Corrections Corp. of America, also known as CCA, and GEO Group (NYSE: GEO  )  are the two largest contracted prison companies. If there's any doubt that these companies are as good as gold, one need only look at CCA's first-quarter report from last week, which saw normalized funds from operations rise by a whopping 35% to $0.70 per share. CCA also boosted its full-year EPS from a range of $2.05-$2.15 to $2.08-$2.16.

CCA and GEO Group are both perfect examples of the law of numbers. The U.S. imprisons a larger percentage of its population than any other country, creating a near endless supply of prisoners and the need for guards and marshals. This is a cash-flow cow at its finest. What makes CCA and GEO Group even more unique is that, as of this year, both are altering their status to become REITs. This means that shareholders moving forward will receive at least 90% of profits in the form of a dividend in return for a more favorable tax rate for the companies. CCA and GEO Group are already yielding in excess of 5%, so short-sellers really may want to think twice about betting against either of them.

No medic needed, but thanks anyway
Hospital and outpatient rehabilitation center operator Select Medical has certainly been a favorite among short-sellers over the past year. Select Medical has had numerous difficulties in meeting Wall Street's forecast profits, and recently lowered its full-year forecast due to the negative effects of the sequester. Yet as I noted last week, now looks like the wrong time to be betting against this particular hospital company.

The implementation of the Patient Protection and Affordable Care Act on Jan. 1, 2014, is going to be a game-changer for the hospital sector. Requiring individuals to carry insurance should, in theory, allow hospitals to see fewer charge-offs because of unpaid services rendered.

Another big factor working in the sector's favor is a considerably more accommodative Centers for Medicare and Medicaid Services. Most analysts had been expecting a decrease in Medicare reimbursement to acute-care facilities but we actually saw an increase in those reimbursements. In short, the reins on the health care sector aren't tightening as quickly as we first imagined, which is great news for hospital operators.

Select Medical is just plain cheap at these levels -- about nine times this year's earnings and eight times next year's. It would take an incredible contraction in reimbursements for Select Medical to fall much further. This is another cash cow that shorts have no business betting against at these levels.

Foolish roundup
This week's theme is all about necessity. An aging, and what you might call naughty, population makes hospital operator Select Medical and private corrections operator CCA somewhat indispensable. Lear, on the hand, could be vulnerable if higher taxes get the better of consumers' disposable income.

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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Related Tickers

8/21/2014 4:01 PM
CXW $35.66 Down -0.15 -0.42%
Corrections Corpor… CAPS Rating: ***
LEA $98.25 Down -0.87 -0.88%
Lear Corporation CAPS Rating: *****
SEM $13.89 Down -0.07 -0.50%
Select Medical Hol… CAPS Rating: ***
GEO $37.59 Up +0.04 +0.11%
The Geo Group, Inc… CAPS Rating: **

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