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 for 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 28 to July 15

Short Shares as a % of Float

Cantel Medical (NYSE: CMN  )

87.6%

3.7%

Socieded Quimica y Minera de Chile (NYSE: SQM  )

144.9%

N/A

Citigroup (NYSE: C  )

32.6%

1.2%

Source: The Wall Street Journal. N/A = not available.

No you Can't-el
Despite no big news since announcing a three-for-two stock split in June and declaring its semi-annual dividend, Cantel Medical, a supplier of infection prevention and control products to the medical industry, has seen its shares go up, up, and up some more! But, shareholders have to be wondering what, if anything, can sustain this rally?

Short-sellers are latching onto the fact that Cantel's valuation may not match the recent run-up in price. In the third-quarter, announced at the beginning of June, Cantel's EPS topped expectations and sales did rise by 8% over the year-ago quarter, but we also saw the negative bottom-line impact of the medical device excise tax under the Patient Protection and Affordable Care Act. This effect could be more pronounced with many other medical device companies struggling with demand outside the United States. Europe's austerity measures have caused orders from that region to slow dramatically, and it's cascading throughout the sector.

On the other hand, Cantel Medical could make for a smarter long-term play on a rapidly aging baby boomer population. A good chunk of Cantel's control and sterilization line isn't dependent on a specific procedure like many other device makers, so it may not see nearly the same slowdown in orders overseas (or domestically) if a recession were to hit.

Overall, I'd have to say I'm intrigued by Cantel's story on paper, but I have a hard time wrapping my hands around a forward P/E of 26 with a single-digit revenue growth rate. Over the very short-term I believe short-sellers may have the upper hand purely based on valuation.

The fertilizer hit the fan
Speaking of stories that make a lot of sense on paper but have had no such luck in translating over to real-world success, we have potash stocks. Potash, a type of nutrient used to help crops grow and improve crop yield, appears as if it's ready to tumble with Russia's Uralkali, the world's biggest producer of potash, signaling that it plans to break from a price-pinning cartel to sell its potash at spot market prices which could be as much as 25% below where they were last week. That's really bad news for margins for potash producers.

Companies that are heavily reliant on potash took it on the chin the hardest. Intrepid Potash (NYSE: IPI  ) , for example, derived 84.4% of its revenue in the second quarter from potash sales, with the remaining coming from langbeinite. Being a much smaller player also doesn't work in its favor because it doesn't have much flexibility in altering its production. It just sort of has to cross its fingers and hope potash pricing comes back with a vengeance.

Socieded Quimica y Minera de Chile, or SQM, felt the same pangs this past week, but shareholders may have overreacted with the company having multiple other chemical and nutrient revenue pathways. The potential for margin contraction is certainly there, and I don't want to completely overlook it -- however, the production diversity and capital capacity of SQM is so much greater than companies like Intrepid Potash that SQM could be getting a bad rap here.

It might be worthwhile waiting out this storm a bit to see what ultimately happens with potash pricing, but I feel SQM has the potential to outperform its peers and disappoint short-sellers from this point out.

What are shorts banking on?
Banking giant Citigroup has certainly come a long way since the depths of the great recession, but, like many of its banking peers, it still has a long way to go.

Citigroup's second-quarter report was a nice surprise for shareholders and reinvigorated excitement in the banking sector that U.S. banks could look overseas for growth opportunities. For the quarter, Citigroup handily topped EPS estimates, growing income by 25% over the previous period last year, and dramatically reduced the value of its bad assets portfolio. With few loan delinquencies domestically and an improving housing market, Citigroup has been able to take full advantage of applying a little foundation to its bad asset portfolio to hide its shortcomings.

The big question mark regarding Citigroup is whether or not its success in overseas markets can continue. Over the past couple of years, overseas investing has been a risky business, with Europe instituting regionwide austerity measures and China's growth engine slowing down. However, Citi's overseas investments saved it from the incredulous views that investors gave conservative banking giant Wells Fargo which sticks to the basics of banking – loan and deposit growth – within the U.S. The roughly 100 basis point spike higher in interest rates really put a damper on Wells Fargo's mortgage investment outlook going forward and constrained its move higher as compared to Citi's.  

At 84% of book value, Citi is no longer the screaming value it once was, but it could still have some room to run higher. If it can yet again halve its bad assets over the coming two to four quarters, I feel shareholders could see a dividend hike and Citi may make a run at a multiyear high.

Foolish roundup
This week's theme is all about balance. Citigroup, with its overseas presence, and SQM with its nutrient and chemical diversity, have the financial capability to respond to changing economic environments. Cantel Medical also has an interesting control pipeline, but it may not have the ability to grow that product pipeline fast enough to justify its rapidly rising valuation.

If you're looking for some long-term investing ideas, you're invited to check out The Motley Fool's brand-new special report, "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so simply click here now and get your copy today.


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