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.

Source: The Wall Street Journal.

Flying high
Shareholders in Southwest Airlines have certainly been privy to a fantastic May that saw the company quadruple its quarterly dividend from $0.01 to $0.04 (vaulting its yield to 1.1%) and boost its share repurchase program to $1.5 billion from its previously authorized $1 billion. Southwest clearly has the cash flow to merit these shareholder-enriching moves, but there's also cause for concern, as evidenced by the dramatic rise in short-sellers.

At 11 times forward earnings, Southwest isn't particularly expensive, but it's also in the process of fully integrating AirTran, which it purchased two years ago. There are innumerable benefits to Southwest's purchase, including international exposure that it previously didn't have; a hub in the world's largest airport, Atlanta-Hartsfeld; and access to busy metropolises. Then again, mergers and acquisitions in the airline space don't always go as planned. United and Continental merged to create United Continental Holdings (UAL 4.72%) in 2010 to realize synergies, reduce expenses, and better compete against the nation's largest airlines. However, last year the merger actually resulted in more costs, not less, for United!

There are ultimately a few factors that will determine whether Southwest remains successful. Reasonably low jet fuel prices, steady to rising passenger traffic, and the struggles of its competitors are likely to give Southwest the lift it needs to head even higher. Admittedly, though, investors should keep their expectations in check for a sector that historically has performed miserably over the long run.

Digging this deal
Walter Energy and the entire coal sector have struggled through an incredibly rough year. Low natural gas prices have persuaded electric utilities to make the switch from coal-burning facilities to natural-gas-powered ones while worldwide steel demand remains muted because of slower growth in China and stringent austerity measures throughout Europe. Unsurprisingly, in its first-quarter results, Walter reported a 22% decline in year-over-year revenue as demand and prices for both coal grades remained weak.

However, it's my contention that the coal sector isn't nearly as bad off as the results make it out to be. In fact, with respect to thermal coal, I would expect to see coal gaining significant ground on natural gas in the coming quarters, with natural gas eclipsing the $4/mbtu mark -- roughly double where it was last year. While natural gas is cleaner-burning, coal still accounts for more than 40% of all electrical generation in the U.S. and will remain a key component to our energy independence.

The steel side of the business is a bit trickier to predict, but it appears that the U.S., South America, and China look ready to pitch in with extra demand. In the U.S., more favorable home prices could encourage homebuilders to ramp up production, which would be great for steel producers. Likewise, emerging-market economies in South America have been relatively immune to overall global market weakness which should spur steel demand in those countries. Even China, with its below-average 7.7% GDP growth rate in its most recent quarter, is more than capable of propping up the steel market.

Walter Energy might look like a disaster now, but it has the economic catalysts, more than ample capital, and the leadership to make it through this downswing.

Hitting the sweet spot
All this talk that the Federal Reserve will scale back -- and potentially even end -- its bond-buying program, which consists of U.S. Treasury notes and mortgage-backed securities, has investors worried, unless you're an investor in mortgage REITs such as Annaly Capital Management and American Capital Agency (AGNC 0.11%).

The fear investors have is that a reduction in the Fed's bond-buying could send lending rates higher, which would reduce lending and hurt businesses and the economy. For Annaly and American Capital, it would mean access to more MBSes. A bigger selection of MBSes to choose from is only bound to increase both mREITs' profitability, since they use heavy leverage to turn big profits on what's normally a razor-thin net interest margin.

Annaly and American Capital both purchase only agency-backed loans (those covered by Freddie Mac and Fannie Mae) and are thus protected against default by the U.S. government. This allows both companies to use significant leverage with few concerns to their balance sheet. Furthermore, with the Fed being upfront about its intent to keep target lending rates at record lows through 2015, it gives these two mREITs incredible visibility, which they can use to their advantage.

These companies look poised to hit the sweet spot of another big growth period, and I would be shocked if their yields didn't stay healthfully in the double-digits.

Foolish roundup
Sometimes it just doesn't pay to be a pessimist, and this week is a good example. While all three companies clearly have challenges that lie ahead, there are more than enough catalysts present that would suggest all three could head higher.

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.