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 June 14 to June 28

Short Shares as a % of Float

Portland General Electric  (NYSE: POR  )

471.2%

16.5%

Chimera Investment Management (NYSE: CIM  )

74.8%

1.4%

Vanguard FTSE Emerging Markets ETF (NYSEMKT: VWO  )

85.1%

N/A

Source: The Wall Street Journal. N/A = ETFs do not have a fixed number of shares outstanding.

A short-selling epiphany
It's pretty rare for short-sellers to flock to an electric utility as we've seen in the case of Portland General Electric. The two reasons short-sellers typically avoid utilities has to do with energy being a necessity item (thus most companies boasting strong pricing power), and utilities being low-beta dividend payers, which makes them naturally unattractive to pessimists.

Despite both factors applying to Portland General Electric, a secondary share offering in June provided the proverbial lightbulb over the head for many short-sellers. The offering for 11.1 million shares, which will be priced at $29.50 and will be used to pay down debt, is a forward sale agreement. Simply put, Portland General Electric will issue shares to an affiliate of Barclays and, sometime within the next 24 months, repurchase those shares, which will then add to Portland General Electric's outstanding share count. While the dilutive effects of this offering are put off for now, they will eventually affect Portland General Electric's EPS negatively and make the company appear more expensive.

In this respect, I somewhat agree with short-sellers, but I think the downside expectations could be quite minimal. In spite of the EPS hit, Portland General Electric emerges from this offering with the same pricing power it had previously, but with less debt. Tack on a 3.4% yield and I feel the gains will be negligible for pessimists.

Is this the end of free money?
Few sectors have more at stake with regard to the Federal Reserve's take on further quantitative easing than the mortgage-REIT sector, which purchases various agency and non-agency loans and mortgage-backed securities.

Low lending rates have allowed companies like Chimera Investment to reap the rewards of wide spreads between the rate at which they borrow and the rate at which they lend. Add on the fact that the Fed has been quite forthcoming with its stance that it plans to keep the Fed Funds target lending rate at historic lows through 2015, and you have all the visibility needed for these mREITs to pile on the leverage. But are the good days about to come to a screeching halt?

Should the U.S. central bank choose to start paring back its monthly bond-buying, mREITs could be negatively affected as interest rates rise. For agency-only mREITs such as Annaly Capital Management, the effect shouldn't be as pronounced. Agency-only mREITs are backed by the government against defaults should they occur, and naturally have lower net interest margin rates than their non-agency counterparts. Simply having more MBS's available on the market to purchase without the government gobbling them up may actually be a positive.

The same may not be true for Chimera, which invests in both agency and non-agency loans. Non-agency loans come with higher margin potential since they aren't backed by the government, but they're also much riskier. Should interest rates rise dramatically, this group of mREITs would feel it the most.

Although I'm actually intrigued by Chimera here off its highs, I still feel that agency-only mREITs are the smarter way to play this sector.

It's the end of the world as we know it, and I feel fine
For years the words "emerging market" have meant one thing to investors: double-digit growth opportunity. Many emerging-market economies offer uniquely independent growth situations that have allowed them to expand despite economic slowness in Europe or the U.S. That trend, though, could be about to reverse, which would be bad news for the Vanguard FTSE Emerging Markets ETF.

As my Foolish colleague and ETF guru Dan Caplinger noted just yesterday, many of these emerging-market ETFs, like Vanguard's, are heavily invested in economies that are finally beginning to show signs of weakness. China, for example, has slowed dramatically from its 30-year GDP average growth of 10% and runs the risk of GDP growth that could fall below 7% this year. Take China Mobile (NYSE: CHL  ) , the ETF's second-largest holding, which reported slowing growth in the first quarter as lower-cost competition in China intensifies despite its huge presence. The story of slower growth has been similar throughout many of the ETF's China-based holdings.

Many of these emerging-market economies also rely on natural resources such as metals to drive growth. With gold, silver, and just about every other metal falling 20%-plus, these economies aren't faring too well.

While I could certainly see short-sellers basking in the sun in the short term while metal prices vacillate wildly, I feel the long term still favors higher growth in many of these emerging-market regions. With an extremely diverse portfolio of stocks, this Vanguard FTSE Emerging Markets ETF still appears to be a smart play for the long run that's worth a closer look.

Foolish roundup
As usual, the theme this week is in identifying whether you're trying to score the short-term buck or long-term gains. Although I can certainly justify short-sellers' actions in all three cases, I just don't see very much downside potential beyond the next couple of quarters.

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.

With the American markets reaching new highs, investors and pundits alike are skeptical about future growth. One need only look at the rising short interest in the above three stocks for evidence of this -- but they shouldn't be. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!


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