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

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 isn't 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 merit.

Company

Short Increase February 14 to February 28

Short Shares as a % of Float

Bank of America (NYSE: BAC  )

40.3%

1.5%

Actavis (NYSE: ACT  )

279.3%

4.3%

General Motors (NYSE: GM  )

44.3%

2.7%

Source: The Wall Street Journal.

Returns you can bank on?
Few consumers are fans of the banking sector, but even fewer investors like Bank of America following the banks' huge 200%-plus run over the past two years.

The basic reasons to avoid Bank of America have remained the same over the past couple of years: lagging metrics relative to its peers and a number of ongoing settlement and lawsuits tied to the housing bubble and recession.

Over the trailing-12-month period, Bank of America's return on assets is a paltry 0.53% while some of its primary rivals such as Citigroup and Wells Fargo are sporting respective ROAs of 0.73% and 1.51%. That alone should grant these other banks a significantly higher multiple than Bank of America in the eyes of short-sellers, and it also points to the bank's inability to generate meaningful income from its loan portfolio. In addition, a mountain of lawsuits and settlements tied to the mortgage crisis and housing crash represents a lingering cloud that continues to hold back Bank of America's share price.

However, as a shareholder of Bank of America myself over these past two years, I still see potential for upside, especially with the company valued at only 83% of its book value.

One factor certainly working in its favor is the short-term memory span of investors. If it can get through 2014 unscathed and without scandal, there's a decent shot it will recover well above its book value.

Rising interest rates are also set to work in Bank of America's favor in 2014. The Federal Reserve's tapering of its economic stimulus known as QE3 will result in fewer long-term U.S. Treasury purchases, which should put pressure on bond prices and move yields higher. While higher yields could pressure Bank of America's mortgage division -- let's face it: What bank hasn't seen weakness in its mortgage division over the past two quarters? -- its interest-bearing assets will see demonstrable gains from their current rate of return. Combining these higher rates with mildly improved public perception should help send Bank of America higher.

In other words, until there's a reason to yell "Fire!" I'm going to remain long Bank of America in my personal portfolio.

You paid how much?
There have been some unexpected buyout announcements over the last few months, but perhaps none was wilder than the announcement last month that Actavis would be purchasing global pharmaceutical provider Forest Laboratories (NYSE: FRX  ) for approximately $25 billion in a mixed cash and stock deal.

The market cheered the deal as Actavis noted that the combined synergies could net up to $1 billion in savings, that the combined company could be capable of $4 billion in annual free cash flow, and that it would be immediately accretive to earnings with double-digit EPS growth to come in 2015 and 2016. To top it off, Forest Labs shareholders received close to a 40% premium to the closing price of their shares prior to the announced deal.

But I'm left wondering exactly what the heck attracted Actavis to Forest Labs in the first place!

The primary allure of Forest Labs is Namenda, the company's Alzheimer's disease drug that accounted for $401.5 million of the company's $846.8 million in revenue during its most recent quarter. This drug is set to lose patent protection next year, wiping away a good chunk of Forest Labs' revenue. Sure, there are bright spots within Forest's pipeline, including Daliresp and Bystolic, whose year-over-year sales increased 53% and 20%, respectively, in the third quarter. Even so, remove Namenda from the equation and Actavis paid a whopping 10-12 times sales for Forest Labs, which looks like an absolute reach to me.

Actavis is going to need a lot of things to go right if its current valuation is going to hold. Forest Labs, for example, filed for a new drug application earlier this month along with partner Adamas Pharmaceuticals for the combination of memantine HCl extended-release and donepezil HCl for the treatment of moderate-to-severe dementia caused by Alzhemer's disease. Actavis had better hope this combination therapy is approved and that its launch is flawless. Otherwise, Forest Labs' pace of revenue growth could take years or longer to justify the price Actavis paid.

Despite the cost savings and cash flow projections, this is a situation where I feel short-sellers may have the upper hand.

The recall to end them all
Recalls can sometimes seem commonplace in the automotive sector, but when you issue a recall covering a handful of models between 2003 and 2007 that totals 1.6 million vehicles, you're bound to get the attention of investors and consumers.

General Motors is currently dealing with one of the largest PR snafus since its bankruptcy declaration in 2009 and short-sellers are apparently letting the domestic automaker have it. Pessimists are anticipating that, despite the offer for a $500 discount on new or leased vehicles moving forward, and the offer to fix the ignition switch issue free of charge at a General Motors dealership, this safety issue will harm domestic sales at a time when it's finally begun to pull away from Ford in U.S. market share.

As for me, I see this as an unfortunate inconvenience for GM but hardly a death knell. The ignition switch fix is relatively inexpensive and can only harm the company more if the consumer becomes concerned that the GM car they own or want to buy isn't safe. CEO Mary Barra appears to be doing a fine job of diffusing that situation and reassuring consumers and investors that GM is going to do the right thing and that this was an isolated safety incident.

General Motors is also seeing strong overseas sales gains in China right alongside archrival Ford (NYSE: F  ) . Both Ford and GM have relied on beefed-up fuel efficiency, sleek styling, and comparable price points to take on Honda and Toyota in China -- and it's working. GM reported a 20% increase in year-over-year vehicle sales for the month of February while Ford reported a blistering 67% increase in sales in China.

With GM recently redesigning its Sierra and Silverado to directly take on Ford's F-Series pickup after eight years without a major overhaul, and Foolish auto analyst John Rosevear noting that the Silverado is spending less time on dealerships' lots than its peers, I'd GM is doing all right at the moment. Ultimately, that's bad news for short-sellers.

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  • Report this Comment On March 18, 2014, at 11:18 AM, SkepikI wrote:

    I suggest you read (or re-read) "Crash of the Titans" and then tell us what a great buy BAC is now at P/E north of 18 and pitiful yield, near its 52 week high. As best I can tell, not much has changed at BAC since 2009, just a few of the faces. Some lessons just need to be learned over and over and over....

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