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 tend to trend upward 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, between 1983 and 2006, even with dividends included, 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 indicating something is off. 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.

Digging itself into a hole
As my Foolish colleague Dan Caplinger recently noted, it's been less than a banner year for rare-earth metals miner Molycorp.

Turning back the clock to 2010 and early 2011, Molycorp's share price was on fire as China restricted rare-earth metal exports from its territory to the rest of the world. With China the primary exporter of rare-earth metals, which are used commonly in electronics, as of 2011 Molycorp was taking advantage of rapidly rising prices and the expectation that the commissioning of its Mountain Pass mine in California would deliver lucrative profits to shareholders. That house of cards, though, has come tumbling down.

China has lifted many of its export restrictions, which has tanked prices for a significant number of rare-earth metals by as much as 90%, dramatically hurting profitability for miners of those materials. Molycorp's prospects have been further crushed by delays at its Mountain Pass mine; the site itself will only exacerbate potential oversupply issues in certain rare-earth metals when those production problems are eventually solved.

In its most recent earnings report, Molycorp delivered a whopping 27.3% decline in revenue to $149.1 million despite selling 19% more metric tons of metals than in the previous year! With losses growing and its cash outflow beginning to raise some eyebrows, I would certainly say that short-sellers could have the upper hand here.

Can anyone really compete?
Every now and then I see the world's largest retailer, Wal-Mart, pop up among the most short-sold stocks over a given period, and I'm just left scratching my head.

On one hand, we are reminded occasionally that Wal-Mart isn't immune to overall U.S. economic weakness. Wal-Mart struggled earlier this year as federal cost cuts furloughed IRS workers, leading to delayed tax refunds for numerous Americans. These refund checks are normally a strong driver of sales in Wal-Mart's second quarter that simply weren't there this time around.

Ultimately, though, it's a sheer case of size and Wal-Mart has the pricing edge over just about any of its competitors. Wal-Mart's diverse product offerings and size enable it to undercut most local stores in price and drive loyalty through steep discounting. Also, because of its size, it's able to negotiate larger-than-average product purchases at favorable rates that keep its costs down relative to smaller chain and local stores.

Wal-Mart is the type of company that could be perfectly set up to drive customer traffic once quantitative easing ends. The potential for higher lending rates could negatively impact credit card holders and drive even more cost-conscious consumers through Wal-Mart's doors. You're certainly not going to find double-digit growth rates here, but it's a business model that can withstand a robust or recessionary economy, and therefore it's not the best shorting opportunity.

High risk, high reward
If you're looking for a company with high-risk, high-reward potential, then perhaps your search should end with metallurgical coal miner Arch Coal.

Arch, like many coal miners, has struggled with weaker prices resulting from a mixture of weak demand, oversupply from China, and in the case of thermal coal cheap natural gas prices that have pushed electric utilities away from older coal-powered plants and toward cleaner-burning energies. For Arch that has meant a greater than 75% reduction in its quarterly dividend and ongoing losses.

As we witnessed last week, Arch is beginning to take aggressive steps to lower its debt interest payments, including reducing its senior credit facility by $100 million, increasing its term loan facility by $300 million, and starting a cash tender to redeem $600 million in notes due in 2016. I project if Arch is able to make this refinancing happen, it could save anywhere from $0.10-$0.20 in earnings per share annually.

I believe Arch is making all of the moves necessary to position its business for long-term success. Although steel demand isn't particularly strong at the moment, Arch is doing what it can to boost exports to China via long-term contracts and has done a good job of controlling other operating and administrative costs. I personally wouldn't think of betting against Arch Coal, but I also completely understand why current short-sellers have their doubts.

Foolish roundup
This week's theme is really all about a company's ability to exert pricing power and/or control. Wal-Mart's size enables it to dictate prices that will drive consumer traffic and command discounts for large purchase orders. Arch and Molycorp, by contrast, have far lesser pricing power. Arch is doing its best to improve that through exports, but Molycorp is really going to struggle as it brings its new mine up to speed and introduces new rare-earth products into an already overcrowded market.