Shorts Are Piling Into These Stocks. Should You Be Worried?

Do short-sellers have these stocks pegged? You be the judge!

Jan 21, 2014 at 11:20AM

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 that 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 their worry has some merit.

Company

Short Increase Dec. 13 to Dec. 31

Short Shares as a % of Float

Zale (UNKNOWN:ZLC.DL)

61.4%

13%

Annaly Capital Management (NYSE:NLY)

43.5%

2.8%

CGI Group (NYSE:GIB)

31.5%

3.4%

Source: The Wall Street Journal.

Losing its luster?
In case you were wondering, I prefer my crow with a little bit of ketchup, because I've been bearish on Zale for years, and the cost-conscious mall-based jeweler crushed short-sellers in 2013.

As you can tell by the sizable increase in short interest above, pessimism in Zale had built up during the weeks leading into the holidays, especially given how weak mall-based teen retailers had performed during the back-to-school season. Expectations for foot traffic weren't good this holiday season, leading many to believe Zale would disappoint. Unfortunately for short-sellers, Zale reported earlier this month that holiday same-store sales rose by 2%, slightly eclipsing the 1.6% growth from the prior-year period and handily surpassing estimates.

Despite these stronger results, I still have my doubts.

For one, Zale's same-store results include the benefit of online sales. That's not to say its online results don't help the top or bottom line, but they could be masking weakness in its brick-and-mortar businesses. Over the trailing 12-month period, Zale has closed 91 stores in an effort to reduce costs and end years of sector underperformance. I suspect that without the boost from its direct-to-consumer business, its same-store sales would likely be down or flat.

The other factor that can't be overlooked here is Zale's incredibly high debt level. If you recall, Zale was rescued from near disaster by a bridge loan from Golden Gate Capital in 2010, and it only recently returned to profitability. The company's $494 million in net debt with minimal cash flow doesn't afford it the opportunity to do much strategically at the moment other than close underperforming stores in order to reduce expenses. Given little, if any, improvement in its top line, I feel short-sellers still have the right idea with Zale.

That's "interesting"
Last year was miserable for mortgage real-estate investment trusts like Annaly Capital Management. Annaly, which makes money on the difference between the rate at which it borrows and the rate at which it lends, tends to do its best in low-interest-rate environments, where its net interest spread is at its highest. As interest rates rise, this net interest spread tightens, which can have an adverse impact on profits and therefore dividends.

The move by short-sellers against Annaly in December came just weeks after the Federal Reserve announced that it would start to taper its monthly economic stimulus, which, through long-term U.S. Treasury and mortgage-backed security purchases, has been largely credited with keeping lending rates near historic lows. Without this essentially free money from the government flowing in on a monthly basis, most economists expect that rates will rise and Annaly's dividend will shrink.

While this statement has merit and those fears are quite real, investors have been pummeling Annaly for nearly a year in expectation of this move, and this beating may be unjustified. For starters, just because Annaly's net interest spread shrinks doesn't mean it won't stay profitable or be able to use leverage to its advantage.

Another key point to recall is that there are two types of mREITs: agency and nonagency. Agency-only mREITs only purchase mortgage-backed securities guaranteed by the full faith of the U.S. government. In other words, if the loans were to default, then the agency-only companies are covered. In return for this safety, investors accept a much smaller return on their investment. Nonagency mREITs can buy riskier MBS products with higher yields, but they could also see their bottom line adversely affected if the economy and those loans went sour. As an agency-only MBS-purchaser, Annaly is protected from the hiccups the economy can experience.

Finally, it's a simple matter of valuation, with Annaly trading at just 80% of book value and likely able to still pay out a dividend in the 8% to 10% range. Emotional investors may have overdone things here, which makes Annaly a potentially dangerous short at these levels.

Somebody get the stretcher
Speaking of companies that could find themselves in the sick ward sooner rather than later, we have CGI Group, the information technology services company behind the buildout of Obamacare's federally run health exchange website, HealthCare.gov, as well as Hawaii and Vermont's state-run health-care marketplaces.

I'm not certain if you've followed Obamacare's early results as much as I have, but no company has been more deserving of finger-pointing than CGI Group. The first two months of Obamacare's live health exchange launch saw a mere 137,204 enrollees via HealthCare.gov and the 36 states it covers, due to innumerable technical glitches with the website. To boot, the Obama administration had to turn to outside contractors to help diagnose and correct many of HealthCare.gov's issues. In addition, Hawaii is the worst in the country as of Dec. 28 when it comes to total enrollment, while Vermont's website is still offline frequently while it gets source-code fixes.

Long story short, CGI's tenure as lead architect for any health exchange has been disastrous -- so disastrous, in fact, that CGI's federal contract will not be renewed when it expires on Feb. 28. The company is being replaced by Accenture (NYSE:ACN), which signed a one-year deal this past week to oversee HealthCare.gov's day-to-day operations.

Although the loss of this one contract certainly won't impact CGI's top or bottom line in a huge manner, the public-relations damage very well could. With multiple recent failures under its belt, CGI Group could find it difficult to secure any large government contracts over the near term, which would almost certainly reduce its earnings estimates moving forward. With revenue growth of roughly 3% to 4% expected this year and next year, short-sellers could have the right idea by placing their bets against CGI Group.

Short-sellers would be wise to keep their distance from this top stock for 2014
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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool recommends Accenture. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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