The S&P 500's 5 Most Hated Stocks

If you're a pessimist, you've been kicked, knocked down, and kicked some more over the past couple of years during the broad-based S&P 500's (SNPINDEX: ^GSPC  ) seemingly unstoppable surge.

Earlier this week the iconic index surged to a new all-time high as tensions between Russia and Ukraine eased. This move came on the heels of a significant drop in the U.S. unemployment rate to just 6.6%, a five-plus year low, as well as steady GDP growth that has encompassed a number of sectors, especially technology and health care. Any pessimists who have stood in the way of the S&P 500, or pounced on even steep one-day pullbacks, have eventually faced heartbreak.

However, it's not as if there aren't telltale signs that the S&P 500 could be nearing a plateau. Being a skeptic myself, I pointed out three reasons in January why everything may not be as perfect as it appears.

For one, the labor participation rate has been falling precipitously for more than a decade, masking what I believe to be a much higher unemployment rate. Second, the Federal Reserve's monetary easing program has been artificially keeping lending rates below their historical average, which has the potential to wreak havoc on the housing and banking industry if consumers reduce the amount of loans they originate. Finally, a rise in share buybacks and cost-cutting by corporations is masking the fact that top-line growth has been somewhat anemic.

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  )

33.26%

GameStop (NYSE: GME  )

30.93%

U.S. Steel 

21.14%

Joy Global (NYSE: JOY  )

21.01%

Frontier Communications (NASDAQ: FTR  )

20.54%

Source: S&P Capital IQ.

Cliffs Natural Resources
Why are investors shorting Cliffs Natural Resources?

  • The bet against Cliffs Natural Resources has revolved around a mixture of weak iron-ore prices and slowing demand from China. Pessimists are making a clear bet that weaker iron-ore prices will pressure Cliffs Natural Resources' margins, while tepid growth in China could pressure demand for the ore used to make steel. With Cliffs slashing its dividend in 2013, pessimists believe they've found a company that could struggle to regain its glory over the long term.

Is this short interest warranted?

  • Iron-ore prices are struggling -- having dropped from $154 per dry metric ton in February 2013 to $128 per dry metric ton in January 2014 -- so this recent dip in Cliffs Natural may be warranted. We're at a point, below $130 per dry metric ton, where I suspect Cliffs' margins could weaken further, which would negatively affect its earnings per share. Yet I believe weakness in demand from China is largely overstated, with GDP growth there still expected to top 7.5%. In addition, Cliffs has taken extensive measures to reduce its expenses, which should translate to stronger-than-expected cash flow. I'd venture a guess that Cliffs has more long-term upside than downside at this point.

GameStop
Why are investors shorting GameStop?

  • Video game and gaming accessories chain GameStop has drawn the ire of short-sellers primarily because of the "buy the rumor, sell the news" mentality. Investors built a mountain of hope around the launches of the Xbox One and PlayStation 4 consoles, but could find those hopes dashed if GameStop doesn't deliver monumentally solid sales results. Considering how long it takes to develop next-generation gaming systems, pessimists predict that GameStop's sales strength will be short-lived.

Is this short interest warranted?

  • Given how badly GameStop's share price imploded after the company reported its holiday figures, I'd certainly say that the bears are right to be skeptical. GameStop does deliver impressive cash flow and did announced a 20% dividend hike earlier this week, but there's just not much in the way of top-line growth once you get the initial sales surge of the Xbox One and PlayStation 4 out of the way. Furthermore, with consumers turning toward digital games, GameStop is struggling to keep up with the curve, with the bulk of its revenue still coming from its brick-and-mortar locations. In other words, it's quite possible that GameStop may have a bigger drop yet to come.

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

  • You could say that commodity and commodity-based companies dominate the S&P 500's most hated stocks. That pattern persists with steel producer U.S. Steel, which has been attacked by short-sellers following years of losses, high debt levels, and weak global steel prices stemming from an oversupply of the metal. Even with the company projected to be profitable this year, pessimists believe that the rebound has already been factored into its share price.

Is this short interest warranted?

  • Based on the fact that U.S. Steel crushed Wall Street's EPS estimates in three consecutive quarters, and expectations that Chinese GDP growth will remain robust, U.S. Steel is no longer the prime short candidate it once was. However, that's doesn't mean I'm giving it a clean bill of health, either. The company still carries a monstrous $3.3 billion in net debt which reduces its financial flexibility and forces it to cost cuts to drive EPS growth. As I've mentioned in the past, if your heart is set on playing the steel sector, there are far safer choices than U.S. Steel.

Joy Global
Why are investors shorting Joy Global?

  • Have I mentioned that commodities are a bull's-eye for short-sellers at the moment? Joy Global, a developer of underground and surface mining equipment, has drawn short-sellers in droves as commodity prices, especially coal, have remained weak. So long as commodity prices remain under pressure, miners are unlikely to place large orders with Joy Global, hurting both its revenue and EPS growth potential. With revenue expected to tumble 26% this year, short-sellers have absolutely begun to pounce.

Is this short interest warranted?

  • While I am looking for a stabilization in coal prices and coal demand in 2014, that's not going to do Joy Global much good as its revenue and EPS estimates fall. A forward P/E of 15 isn't egregiously high by any means, but when revenue is slated to drop by 26% in 2014 and rebound by less than 4% in 2015, it could be a concern. On the bright side, Joy Global is also well-capitalized and capable of cutting costs as needed to reduce expenses. If you're in this stock for the long term, I don't believe there's too much to worry about.

Frontier Communications
Why are investors shorting Frontier Communications?

  • Telecom and broadband service provider Frontier has become something of a fixture on this list as short-sellers are placing their bet that another dividend cut -- the primary reason investors purchase Frontier is to take advantage of its 8% yield -- could be in the offing. Frontier has been losing a smaller number of higher-margin rural landline customers in recent quarters, but it's been unable to fully stem that outflow as wireless coverage extends through rural America. As wireless coverage improves and Frontier's subscriber level shrinks, the ability to maintain its hefty dividend could be challenged.

Is this short interest warranted?

  • Frontier's weakening landline subscriber base will continue to be a concern given that it's a high-margin business segment. However, Frontier has also done a good job of tacking on modest broadband gains and slowly reducing its debt load. This isn't to say that risks don't exist with Frontier, but for the moment its healthy yield looks safe and it should remain decisively profitable. The high short interest here doesn't make a lot of sense to me.

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