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

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

Feb 17, 2014 at 2:15PM

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 worries have some merit.

Company

Short Increase Jan. 15 to Jan. 31

Short Shares As a % of Float

Caterpillar (NYSE:CAT)

71.9%

6%

Alcatel-Lucent (NYSE:ALU)

89.8%

0.6%*

American Eagle Outfitters (NYSE:AEO)

51%

8.9%

Source: The Wall Street Journal.
*Outstanding share data from Yahoo! Finance, author's calculation.

Life's a garden. Dig it.
Yes, I just watched the movie Joe Dirt with David Spade, but there are a number of similarities between Caterpillar and the overall theme of the movie. Most notably, both Joe Dirt and Caterpillar look a bit rough on the surface and are going to need to do a bit of inner searching to find their course, but over the long term they're two things you can count on.

Last year was not Caterpillar's best effort by any means, with the company lowering its full-year outlook on three separate occasions as commodity prices weakened around the globe and caused miners to holster their pocketbooks. This lack of mining orders more than offset gains in construction equipment and has pushed Caterpillar to be more cautious about its near-term outlook than I can personally ever recall.

The good news is that if you have a long-term investment horizon, then Caterpillar could be right up your alley. Being globally diversified and with little competition gives Caterpillar superior pricing power. In addition, the finite amount of global resources that miners are unearthing should push long-term commodity prices, and thus mining equipment demand, higher. Let's not also forget that Caterpillar has demonstrated its ability to cut costs as needed to improve profitability and isn't shy about repurchasing its own shares in order to boost EPS and improve shareholder value.

What this really comes down to is investing timeframe. If you're looking for a quick buck and want to roll the dice, then betting against Caterpillar may make sense, as the global mining outlook is far from improved. However, if you envision Caterpillar in a long-term downtrend and losing market share to smaller rivals, then you're likely to be sorely mistaken.

Don't be fooled by more of the same
If you couldn't tell by the near-quadrupling in Alcatel-Lucent's share price over the past year, things are slowly improving for the Internet protocol and cloud-networking specialist.

Alcatel-Lucent certainly deserves the benefit of the doubt as it's ramped down its costs to the point where it was able to produce a solid profit in the fourth-quarter. Small, but still notable market share gains and improved IP and LTE technology contract wins helped fuel Alcatel-Lucent's results from a prior-year loss to a profit.

But even with this profit there are concerns I possess that could stymie Alcatel-Lucent in its tracks. To begin with, Alcatel-Lucent's top-line growth is practically nonexistent, with fourth-quarter revenue flat year-over-year. What gains were witnessed in IP and LTE technologies were offset by a 7% decrease in its core networking segment. This is highly disconcerting, as we're in the midst of a major spending surge from telecom service providers, and we're seeing Alcatel-Lucent's core networking revenue declining.

Also, it's a simple case of valuation. For the year, Alcatel-Lucent is only expected to be ever-so-slightly profitable as its revenue declines another 4%, based on Wall Street estimates. Looking ahead, Alcatel-Lucent's forward P/E is only 20 for 2015, but that's with revenue levels flat from where they're at now. Is it really worth paying 20 times forward earnings for a company with no top-line growth? I'd surmise that Alcatel's cost-cuts are already priced into the stock, making a purchase here a risky proposition.

Teeny-bopped
In case you'd forgotten that the apparel industry is cyclical, shareholders of teen-retailer American Eagle Outfitters received an unwelcome reminder over the past couple of months.

The first sign that all was not well with the sector came during the back-to-school season where it, Aeropostale (NYSE:ARO), and Abercrombie & Fitch (NYSE:ANF) all reported high-single-digit or mid-teen percentage declines in sales on a year-over-year basis. These declines point to a considerably more skittish consumer. American Eagle's problems were further exacerbated recently when it lowered its upcoming quarterly outlook and announced the departure of CEO Robert Hanson, who resigned after less than two years on the job in January.

But, I have good news, shareholders ... American Eagle is just fine! It's been my position from the get-go that American Eagle is the best-positioned teen retailer of the bunch, primarily because it's the only brand that can appeal to teens' desire for brand-name ownership as well as the parents' pocketbooks. Abercrombie's numerous PR gaffes and higher price point tends to cause it more violent peak-and-trough swings. On the flipside, while Aeropostale meets the price point that parents love, teens have shied away from its clothing because it lacks the brand-name appeal of American Eagle or Abercrombie. American Eagle Outfitters, though, fits the price and brand-name niche perfectly, allowing teens to purchase exclusive American Eagle-branded merchandise without bankrupting their parents' bank account.

American Eagle Outfitters has also historically had a superior management team. I admit I was disappointed to see Robert Hanson depart after less than two years on the job, but American Eagle's corporate decisions consist of more than just a single person. The company is a mastermind at getting inside teens' heads with regard to fashion, and is often faster to respond to industrywide changes than any company in the sector. With a hefty dividend and remaining healthfully profitable, it's a company I'm possibly looking to add to my own portfolio.

This easiest way to avoid short-sellers is to find great stocks and hold them forever
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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 has no position in any companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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