The S&P 500's 5 Most Hated Stocks

January was anything but a banner month for the broad-based S&P 500 (SNPINDEX: ^GSPC  ) , with the iconic index turning in one of its worst months in years. Despite this minor victory for short-sellers, it's been a relatively straight shot upward for the index over the past five years.

A number of factors have contributed to the ongoing strength behind the rally in the S&P 500. The U.S. economy delivered 4.1% GDP growth in the third quarter, and preliminary estimates for the fourth quarter show still-robust growth of 3.2%. The manufacturing sector is also showing a healthy expansion, with the Chicago PMI last week coming in with a reading of 59.6 (anything more than 50 signals expansion). The unemployment rate has dropped to 6.7%, its lowest reading since July 2008. In all respects, the nation's economy is giving investors every reason to believe this economic rebound will continue.

Source: Eva K., Wikimedia Commons.

But, as a growing number of skeptics will tell you, not everything is as it appears.

Last month, I outlined three ways that U.S. consumers are being tricked into believing the economy is perfectly healthy. While I encourage you to read the more in-depth discussion, the three factors that are masking slower growth are: a falling labor-participation rate, which makes the unemployment rate seem rosier than it actually is; the continuation of quantitative easing, which is artificially keeping interest rates low and spoiling the U.S. consumer; and a dramatic increase in the number of share buybacks and cost-cutting maneuvers used to mask a lack of top-line growth.

With these concerns in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's five most hated stocks. Why, you ask? Because this way we can better understand what characteristics, if any, attract short-sellers so that we can avoid buying similar companies in the future.

Here are the S&P 500's five most hated companies:

Company

Short Interest as a % of Outstanding Shares

Cliffs Natural Resources (NYSE: CLF  )

33.8%

GameStop (NYSE: GME  )

24.56%

U.S. Steel (NYSE: X  )

22.42%

ADT (NYSE: ADT  )

22.32%

Frontier Communications

19.6%

Source: S&P Capital IQ.

Cliffs Natural Resources
Why are investors shorting Cliffs Natural Resources?

  • I've actually lost count of how many months in a row now Cliffs Natural Resources has been the most short-sold company in the S&P 500, but rest assured, it handily held its No. 1 position again in January after a dismal monthly performance. The case against Cliffs Natural Resources remains the same as it's been in previous months: Iron ore prices are weak, and China's manufacturing demand is shrinking, which could reduce its commodity-based demand even further. With Cliffs slashing its dividend last year by roughly three-quarters and not exactly knowing when prices or demand will improve, investors are using this uncertainty to load up on bets against the iron-ore and metallurgical-coal miner.

Is this short interest warranted?

  • I'm a bit torn here, because there's absolutely no reason short-sellers shouldn't be skeptical of Cliffs, given its sizable recent dividend cut and relatively uncertain near-term steel demand. Then again, iron ore prices have staged a sizable rebound from their low point in 2013, and China's commodity demand hasn't tapered off anywhere near as badly as expected. In addition, last week private-equity investment firm Casablanca Capital took a 5.2% stake in Cliffs, sending a letter to management calling for changes, including a spinoff of its Bloom Lake and international assets, as well as a conversion of its U.S. assets into a master limited partnership, which would help the company from a tax perspective and boost shareholder dividends. This activist investor interest, coupled with Cliffs' single-digit forward P/E, make it an attractive company at these levels.

GameStop
Why are investors shorting GameStop?

  • It's pretty easy to dislike the gaming sector in general, because the timeline for development for new video-game consoles only seems to get longer between each next-generation system. Meanwhile, most games are moving toward a digital format. Also, GameStop's brick-and-mortar presence gives it less flexibility than online game companies, which have lowered overhead costs. Finally, there's the simple fact that the introduction of the PlayStation 4 and Xbox One in 2013 will make comparable-store sales practically impossible to top over the coming year. In other words, it's a "buy the rumor, sell the news" type of scenario.


Source: GameStop.

Is this short interest warranted?

  • Based on GameStop's miserable holiday sales update, I'd say short-sellers have been prescient in their call. In mid-January GameStop noted that global sales jumped 9.3% to $3.15 billion for the holiday season, but its growth was offset by a big reduction in Xbox 360 and PlayStation 3 sales (as if this were somehow unforeseen?). Ultimately, GameStop lowered its fourth-quarter earnings-per-share guidance to a range of $1.85-$1.95 from prior expectations of $1.97-$2.14, and the stock tanked. While GameStop will have a downside buffer due to its strong cash flow and high margins from reselling used games, it will find same-store comparisons increasingly difficult over the coming years and is unlikely to see another next-generation console boost for a number of years. It may be time for optimists to begin heading for the exits.

U.S. Steel
Why are investors shorting U.S. Steel?

  • The bet against U.S. Steel has been a bet against an increase in steel prices and demand domestically and from China. Although this has been a trend we've witnessed across much of the sector, it has hit U.S. Steel particularly hard because the company carries a higher percentage of debt relative to equity than most of its peers. Another factor that has really sacked U.S. Steel, at least in the past couple of quarters, has been a number of one-time charges that have resulted in exorbitant noncash EPS losses.

Is this short interest warranted?

  • After a near-doubling in the share price since May, short-sellers have every right to be skeptical of U.S. Steel. The steelmaker's fourth-quarter results on Jan. 27 delivered a much-welcomed adjusted EPS profit of $0.27, compared to a hefty year-ago loss as demand and pricing for a number of its products improved and its expenses dipped. However, looking ahead, the company's critical tubular-products segment is expected to see pricing weakness in the first quarter, and it's still dealing with $3.3 billion in net debt, which may make it difficult for U.S. Steel to make strategic moves, should the opportunity or need arise. A forward P/E of 12 may not seem expensive, but when you're dealing with minimal top-line growth and a lot of debt, it's a good recipe for attracting short-sellers.

ADT
Why are investors shorting ADT?

  • As we saw last month, short interest in electronic security solutions provider ADT has been rising precipitously in the past couple of months, but until recently it had been a bit of a struggle to figure out why. The prevailing thesis pessimists were relying on was the company's weak top-line growth and hefty share buybacks that masked weaker operational EPS and margin growth. Add in a significant amount of debt, and short-sellers have been betting on ADT to tumble.

Is this short interest warranted?

  • Based on ADT's first-quarter results, I'd say this short interest is unequivocally deserved. For the quarter, reported late last week, ADT saw a revenue increase of just 4% as EPS dipped 11% despite the company's best efforts to buy back shares. The long-term problem for ADT, which doesn't have a visible solution at present, is how it will lower its subscriber acquisition costs and retain existing customers without having to spend a boatload of money. With $4.4 billion in debt, it's not as if ADT has a lot of flexibility, in my view. Pessimists have every reason to sink their teeth into ADT here.

Frontier Communications
Why are investors shorting Frontier Communications?

  • Telecom service provider Frontier Communications has actually seen a minor retracement in short interest over the past couple of months. Pessimists have been generally sticking to Frontier because of its ill-timed purchase of landline assets from Verizon a few years back, which left it with a hefty amount of debt and an ongoing exodus of landline customers who no longer need a home phone as cellphone service improves into rural areas. These short-sellers are counting on a possible third dividend cut for Frontier in order to save capital and an ongoing drop in high-margin landline customers.

Is this short interest warranted?

  • While Frontier has done little to slow the attrition of landline customers -- and it's not as if much can be done -- it has still generated significant cash flow and healthy margins from these customers, which is allowing it to reduce debt and pay out an 8% yield. Generally speaking, short-sellers don't like high-yielding companies as they can be painful in the pocketbooks come dividend time, since short-sellers owe what currently amounts to 8% per year in stipends. With Frontier confident that it can maintain cash flow to pay down its debt and continue to generate $0.40 in annual dividends, I see few telltale downside catalysts.

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