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 May 15 to May 31

Short Shares as a % of Float

Merck (NYSE: MRK  )

303.2%

3.1%

Zoetis (NYSE: ZTS  )

1,037.2%

19.2%

Kellogg (NYSE: K  )

118.2%

2.7%

Source: The Wall Street Journal.

An ailing pipeline? Hardly!
For a big pharmaceutical company like Merck that pays out a hefty 3.6% yield and demonstrates very low volatility (its beta is just 0.37), it's a bit surprising to see its short interest more than quadrupling.

About the only factor I can think of that would cause such pessimism among investors is the potential that patent expirations will ravage Merck's cash flow before new drugs can be approved or purchased to replace this lost revenue. For Merck, these fears manifested themselves in the loss of exclusivity of asthma drug Singulair last year, which had topped $5 billion in annual sales at its peak. In its most recent quarter, Singulair sales fell by 75%. 

However, plenty of very-early-stage and new drug approvals could prove short-sellers wrong about Merck's pipeline. In May, Liptruzet, an LDL-cholesterol-lowering drug that combines Pfizer's (NYSE: PFE  ) now generic statin, Lipitor, with Merck's cholesterol absorption inhibitor, Zetia, was approved by the Food and Drug Administration. The combo drug did far better in lowering LDL cholesterol (the bad type) than the two drugs did individually. 

Another bright spot was the recently completed American Society of Clinical Oncology's annual meeting. Merck wasn't expected by many to make a strong showing, but wowed investors with its experimental PD-1 inhibitor, lambrolizumab. Most investors and science enthusiasts had their eyes on Bristol-Myers Squibb's nivolumab, which demonstrated an overall response rate of 40% in trials. But it was lambrolizumab, with its overall response rate of 38%, that excited investors -- especially since it has the "breakthrough therapy" designation from the FDA, which would help streamline its development. Anti-PD-1 drugs could be the future of targeted cancer therapy, so both Bristol and Merck deserve close attention.

Paws off, short-sellers!
Perhaps as equally confusing as the dramatic rise in short interest in Merck is the jump in pessimism surrounding animal medicine and vaccine maker Zoetis.

The best picture I can surmise that would cast doubt over Zoetis is the upcoming spinoff of Pfizer's remaining 80% stake. Current Pfizer shareholders have the opportunity, if they choose, to tender their shares in exchange for shares of Zoetis. Depending on the number of shareholders who take part in this tender, Pfizer could retain no stake in Zoetis, a partial stake, or it could still boast a majority voting stake. To me it would be more advantageous for Zoetis to be able to run its business independently of Pfizer, so this slight gray cloud of worry could be the short-selling culprit. 

Zoetis' results, though, speak wonders to a growing trend of pet domestication in American households. More than 60% of American households currently own a pet and a majority of those pet-owning households (91%, to be exact) now consider that pet a member of the family. This is an important aspect, as those households will do whatever's necessary to ensure the health of their pet. Zoetis, with a full line of preventative vaccines and disease treatments, is in line to see steady growth from this growing trend.

Furthermore, few pet owners actually have health insurance on their pets. This means higher margins for animal-focused pharmaceutical companies, since the money is coming directly out of consumers' pockets instead of insurers'.

Bet against Zoetis? I'd give that idea four paws down!

Once you pop, you can't stop!
Kellogg is certainly making Tony the Tiger proud, as its share price performance over the previous year has been nothing short of grrrrrrrrrrrrreat! But a doubling in short interest could signal that the good times are about to come to a crashing halt.

The impetus for Kellogg's run has been its $2.7 billion all-cash purchase of the Pringles brand from Procter & Gamble (NYSE: PG  ) last year. The deal was a win for both companies, as snack brands have been one of the few strong growth areas globally, helping offset weaker growth in Kellogg's breakfast line. For P&G, it gave the company ample cash to revamp its marketing campaign and instill confidence in its core brands, including detergent Tide.

The concern I have for Kellogg is that we're going to need to see a lot more than just acquisition-based growth. Kellogg has tried to transform itself from being just a breakfast company for years, but has been largely unsuccessful in doing so. With its comparable sales growth of just 2.2% last quarter, I'm not sure it merits a forward P/E of even 15.

Kellogg's current valuation also assumes that food cost inflation will be nonexistent, which is something that history has shown is rarely the case.

I believe enough doubt exists in Kellogg's current valuation to justify an increased level of skepticism.

Foolish roundup
This week's theme is all about recognizing the difference between organic growth and acquisition-based growth. Merck and Zoetis both have the tools needed to grow their product pipelines from within. Kellogg, on the other hand, may not be able to meet investors' lofty expectations without going shopping for growth once again.

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.

Merck stumbled into 2013 and continues to battle patent expirations and pipeline problems. Is this titan of the pharmaceutical industry still a solid dividend play, or should investors be looking elsewhere? In a new premium research report on Merck, The Fool tackles all of the company's moving parts, its major market opportunities, and reasons to both buy and sell. To find out more, click here to claim your copy today.



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