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 30 to May 15

Short Shares as a % of Float

Albemarle (NYSE: ALB  )

330.4%

8.4%

Newcastle Investment (NYSE: NCT  )

106.9%

1.8%

AT&T (NYSE: T  )

13.7%

1.5%

Source: The Wall Street Journal.

An explosive reaction
If "Opposite Day" was an actual holiday, then consider specialty chemicals maker Albemarle on temporary vacation.

The maker of specialty polymers and catalysts used by the electronics, automotive, and refining industries reported first-quarter results in late April that fell well short of Wall Street's estimates. Net income for the quarter fell by 26% as sales declined 10%, with management pointing to continued weakness in the coming quarters because of weak electronics sales domestically and sluggish auto sales in Europe.

Despite these poor results, Albemarle's share price has been on fire, presumably under the suspicion that domestic economic data is improving and that, at 11 times forward earnings, Albemarle could still be an intriguing value. As for me, I'm putting my trust in short-sellers -- at least in the short-term.

That earnings report was ghastly! The company's catalyst segment -- its largest -- saw sales plummet by 20% while its polymer segment managed higher-volume sales but saw prices slump badly. This is not a recipe for success. The company did boost its dividend by 20% and initiated a massive share repurchase program that'll buy back 10% of all outstanding shares by year's end in an effort to support shareholders; however, it did nothing to address how to grow the business. Until we see prices improve and Europe's economy stabilizes, this is a company I'd suggest avoiding altogether.

Steady as she goes
Despite a steady return to profitability, the distrust of residential mortgage-backed security and commercial real estate debt holder Newcastle remains evident.

Newcastle recently declared a quarterly payout of $0.17 per share, which, while down from the $0.22 paid out in the previous quarter, would still equate to an annualized yield of 12%. Furthermore, the company completed its spinoff of former subsidiary New Residential Investment (NYSE: NRZ  ) in early May. This new company does own nearly half of Newcastle's asset portfolio and should make it easier for investors to understand how Newcastle makes its money, and could help unlock value in Newcastle's share price, which is notably below book value.

However, I'd be quick to point out that while the underlying financials are improving dramatically, there's still a major risk that could cripple Newcastle. Newcastle relies on a stable economy in order to pay out huge dividends and remain healthfully profitable. Quite a bit of its portfolio is devoted to below-investment-grade mortgage securities and debt, which puts it at a significant disadvantage if the economy turns south. Unlike agency REITs, which can lever up with the understanding that their loans are backed by the U.S. government, part of Newcastle's asset portfolio has no fail-safe, meaning it takes MBS defaults on the chin. This means that if the Federal Reserve begins paring back its bond-buying program, Newcastle investors should be on high guard in case housing growth slows to a crawl or even retreats.

Playing catch-up
I can somewhat understand the reasoning behind a bet against telecom services giant AT&T, because in terms of next-generation wireless services, Verizon (NYSE: VZ  ) is running circles around its peers. Verizon is covering far more active 4G LTE-capable cities than AT&T, Sprint Nextel, and T-Mobile combined, which gives it an inherent advantage in acquiring new customers. In AT&T's latest subscriber figures, we saw these struggles become apparent as it did add 296,000 new net subscribers during the quarter, but actually lost 69,000 high-value phone subscribers.

However, who in their right mind would bet against the inelastic pricing dominance of AT&T or its incredibly steady cash flow? We've witnessed AT&T's commitment to catching Verizon with its plans announced last year to spend $14.4 billion on wireless infrastructure upgrades over the next three years. Although the trickle-down effect of these infrastructure upgrades tends to help network-equipment providers long before we see any follow-through in service providers, make no mistake about it: AT&T will see these benefits soon enough.

AT&T is also getting increasingly optimistic about its future. The company is forecasting net additions of 500,000 subscribers in the second quarter, which would be a nice improvement. With a 5% yield and a product that borders on necessity, this isn't a company I'd recommend betting against.

Foolish roundup
This week's theme is all about whether or not the business is healthy. Forget the dividends and the buybacks; can the business grow? For Albemarle, that question is still unanswered, while plenty of question marks could exist for Newcastle, too. In AT&T's case, its pricing power and wireless upgrades look poised to provide the growth needed to drive its share price even higher for years to come.

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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Read/Post Comments (3) | Recommend This Article (3)

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 June 10, 2013, at 12:45 PM, sailrmac wrote:

    I think you misunderstand NCT (and the NRZ spinoff).

    NCT holds commercial paper so, "This means that if the Federal Reserve begins paring back its bond-buying program, Newcastle investors should be on high guard in case housing growth slows to a crawl or even retreats." is probably not correct. NCT should not be very much effected by housing changes one way or the other.

    NRZ holds all the housing related paper, both MBS (mortgage backed securities) and MSR (mortgage servicing rights). If worries about housing are going to effect anything it would be NRZ not NCT. However even there I think your warning is incorrect. The MBS portion of NRZ's portfolio could be hampered by the fed tapering it's bond purchasing. The book value of these MBS could go down due to higher rates. However, those higher rates are also indicative of an improving economy which increases the value of discounted MBS. So for the MBS portion of NRZ's portfolio it could be a wash. More importantly the MSR portion of NRZ's portfolio actually benefits from higher rates. As rates go up, people are less likely to refinance and thus the payment stream from those MSR's lengthens. The fed tapering purchases would clearly increase the value of New Residential Corp's MSR's.

    I think the more likely explanation for 1.8% in short interest on NCT is tax avoidance. Many, myself included, invested in NCT almost a year ago because they were interested in owning MSR's (mortgage servicing rights). Those MSR's went with NRZ so they are no longer as interested in NCT. However, NCT has doubled in value, so we are sitting on large taxable gains if we sell. Thus if one were interested in selling the NCT holding and repositioning it to the NRZ holding, it make sense to hedge NCT for a few months waiting to gain tax favored status before selling it and buying NRZ.

    I considered doing this (hedging the NCT portion and selling once I achieved the tax favored one year of ownership) but decided I like NCT's commercial holdings well enough to just continue hold. They should do fine, producing a high single digit dividend for years. I did however strongly prefer NRZ, so I just tripled my position there utilizing new money.

  • Report this Comment On June 11, 2013, at 10:31 AM, duzer5 wrote:

    You covered better than the writer above. PS: I went the other way-sold NRZ immediately and bought NCT, it was like a 2 for 1 split with money in my pocket. GL2U

  • Report this Comment On June 11, 2013, at 2:00 PM, navydog11 wrote:

    Thanks for the comments sallmac and duzer5. I cannot help but think that NCT is terribly misunderstood.

    With regard to the MF article, I think it's best not to refer to the $0.17 quarterly dividend as a decline from the prior quarter's $0.22 dividend. NCT is paying $0.17 and NRZ is paying $0.07 per quarter. So the combined quarterly dividend increased from $0.22 to $0.24 (annually, an increase of $0.88 to $0.96). For those of us that purchased NCT prior to the spinoff, that's the way we look at it.

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