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

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

Feb 24, 2014 at 5:16PM

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

General Dynamics (NYSE:GD)

380.6%

4.7%

Altria (NYSE:MO)

23.5%

1%

GameStop (NYSE:GME)

25.4%

31.4%

Source: The Wall Street Journal.

Sniffing for growth
Short-sellers have apparently caught the stench of stagnant growth from aviation, shipbuilding, and technology systems developer General Dynamics, which reported subtly improved fourth-quarter earnings results last month.

For the quarter, General Dynamics' top-line grew by a meager $29 million to $8.11 billion -- just a 0.4% improvement. However, its bottom line expanded rapidly as it cut operating costs and expenses by a whopping $2.8 billion, allowing the company to report operating income of $921 million. Even including a $129 million loss tied to a settlement for its A-12 litigation, General Dynamics still earned $1.76 in EPS, nudging slightly above estimates.

The view of short-sellers is twofold. First, that General Dynamics makes little sense on paper since the U.S. government is working to cut back on federal spending, including the defense budget, in an effort to reduce the deficit. This means a tougher orders environment over the coming years for General Dynamics.

The other factor is valuation-based. General Dynamics isn't particularly expensive at 13 times forward earnings, but when you factor in the expectation that its revenue will fall 3% this year and rise 1% next year, you can see that the general trend is for weaker revenue.

Then again, here's what short-sellers also need to consider: Betting against cost-cutting is a prudent long-term move, but General Dynamics only recently took to trimming its expenses to boost its profits. It could have a number of additional quarters of cost-cutting up its sleeve to help it surpass Wall Street's expectations.

Also, General Dynamics' total backlog ended the year at $46 billion, meaning there are years of amortized contracts and profits built into these deals. In other words, General Dynamics is unlikely to roll over and report a terrible quarter out of nowhere.

This is one of those instances where I agree with both sides and would call it a stalemate. General Dynamics' cash flow and cost-cutting ability would certainly make me shy away from betting against it, but the government's ongoing federal-deficit cuts and the company's already weak top-line make me worry that its share price won't be heading much higher.

Time to butt out?
Are domestic tobacco-producers about to be choked out by growing regulations in the U.S.? Short-sellers certainly seem to think so -- by the end of January, there were 3.7 million more shares held short in Marlboro maker Altria than in the previous two-week period.

Altria, despite these worries, does have a number of factors working in its favor. For one, tobacco products -- especially cigarettes -- are incredibly addictive, which keeps its consumers attached and coming back for more. Second, Altria has amazing pricing power because of that addiction, and can simply overcome business weakness with price boosts in its premium brands. Finally, because the tobacco business is relatively low-cost, Altria is a cash flow machine that's cranking out a current yield of 5.4%.

But there are a number of worries, too. Tougher regulations could continue to weigh on cigarette shipment volume and force Altria to boost its prices even further. At some point, higher prices will begin to adversely impact smokers' ability to afford their habit. Also, Altria is managing most of its current growth through cost-cuts -- including laying off about 15% of its workforce -- and share repurchases, which mask actual top-line growth. Although Altria's fiscal 2014 forecast calls for 11%-14% growth in its EPS thanks to share buybacks, lower corporate taxes, and price increases, its fourth-quarter and fiscal 2013 tobacco products shipments fell 5.8% and 4.1%, respectively!

I'm certainly no fan of the tobacco sector and would absolutely suggest that short-sellers could be in the right here over the long-term. If, however, you can't get enough of these dividends, I would urge you to consider pursuing Philip Morris International (NYSE:PM) instead.

Philip Morris operates in dozens of countries around the world, which means it isn't exposed to the regulatory tobacco laws of just one country like its former parent Altria. In addition, Philip Morris is operating in regions with immense growth and higher percentages of smokers, such as China and India. Not to mention its dividend yield is also an impressive 4.8%.

Game. Stop!
Finally, we have gaming and accessories retailer GameStop, which was massacred in January after the company updated its fourth-quarter and full-year EPS guidance, pushing them modestly below Wall Street's expectations despite a 10.2% increase in same-store sales during the nine-week holiday season. This figure, ironically, was actually much higher than anyone had anticipated. So where to next?

My suggestion, despite GameStop's clearly impressive cash flow and sub-10 forward P/E, is that it could have additional weakness and/or downside to come.

One of the biggest obstacles that GameStop is going to face is its own same-store sales figures. For the first couple of months sales of Microsoft's Xbox One and Sony's PlayStation 4 should boom, right along with the games used for those systems. However, it's going to be almost impossible for GameStop to deliver high single-digit same-store sales growth month in and month out when we know from history how consumer sales trends play out when a new console is introduced.

Also, we have to understand that console development takes years, and GameStop is, in the meantime, being pushed by digital game developers. This doesn't mean GameStop is sitting on its hands, because it, too, is developing digital-based gaming solutions, but this still equals such a small portion of its revenue that GameStop's bricks-and-mortar stores could act as a crutch rather than aid over the next year as its results come back down to reality.

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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 owns shares of GameStop, General Dynamics, Microsoft, and Philip Morris International. 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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