The Dow's 3 Most Hated Stocks

The technology and biotech sectors have both been beaten up recently, and high-flying small-caps have taken a licking. However, the most iconic stock market index of them all, the Dow Jones Industrial Average (DJINDICES: ^DJI  ) , closed Friday at yet another all-time record high.

The Dow and most of the major indexes have been practically unstoppable thanks to a steady rebound in the U.S. economy, as well as the accommodative stance of the Federal Reserve to keeping the federal funds rate at 0.25%. Keeping rates low has been instrumental in allowing businesses to lower their interest expenses through refinancing, as well as to borrow at extremely attractive rates in order to expand – and remember, expanding businesses means more jobs and lower unemployment. With the Fed beginning to taper its economic stimulus known as QE3 it's become apparent to optimists that the U.S. economy is ready to stand on its own two feet once again.

Yet not all traders are in agreement that the Dow should be heading any higher. As pessimists would point out one of corporate America's greatest tricks has been its use of share repurchases and cost-cutting to drive up margins and boost profits in the wake of weak or nonexistent organic growth. While it's helped sustain profits for a number of companies, short-sellers realize this isn't a long-term solution since cost-cutting only takes a company so far.

In addition, some would say the unemployment picture doesn't tell the full tale, either. With the labor force participation rate falling precipitously for years it's artificially lowered the current unemployment rate of 6.3%. A better comparison would be a constant labor force participation readout which shows that nonfarm payroll growth has been flat over the past six years.

With these points in mind, I suggest we do what we do every month, which is take a closer look at the Dow's three most hated companies -- in essence, the three stocks with the highest level of short interest -- to better understand what characteristics, if any, are attracting short-sellers so we can avoid buying similar stocks in the future.

Here are the Dow's three most hated stocks.

Company

Short Interest as a % of Outstanding Shares

Intel (NASDAQ: INTC  )

4.08%

Caterpillar (NYSE: CAT  )

3.84%

AT&T (NYSE: T  )

3.8%

Source: S&P Capital IQ.

Intel
Why are investors shorting Intel?

  • Short-sellers continue to bet against chipmaker Intel because the company is behind the curve when it comes to adapting to the mobile and cloud revolution. Despite a veritable monopoly in PC chip sales, this market is shrinking, so pessimists rightly understand that Intel is going to need to spend heavily on research and development in order to catch up. These extra expenses and a relatively flat top-line mean stagnant profits for Intel, which could play right into the hands of pessimists.


Source: Intel.

Is this short interest warranted?

  • Skepticism is certainly warranted, but I don't see any reason for short-sellers to actually follow through with a bet to the downside here. Although Intel's PC revenue is shrinking, the cash flow from this segment is more than enough to support its healthy dividend as well as ongoing R&D into mobile chips and data center solutions. Thus far Intel has had very little success in infiltrating the smartphone market, but early success in tablets and especially in big data center hardware demonstrates that the company is on the right track. In its first-quarter results, for example, the company boosted its R&D guidance for the full-year by $300 million, but also raised its margin forecast by 1% to 61%. There's going to be a give and take going on here for a while between Intel optimists and pessimists, but its cash flow, cloud potential, and dividend should keep short-sellers at bay.

Caterpillar
Why are investors shorting Caterpillar?

  • Pessimists have piled into Caterpillar primarily due to long-term weakness in the construction and mining sector which have plagued orders for the heavy equipment manufacturer and made its earnings visibility somewhat murky. Sizable dips in precious metal commodities have caused mining companies to drastically reduce their capital expenditures, while construction growth around the globe has been hit-or-miss at best. Having reduced its full-year EPS forecast three times in 2013, short-sellers are counting on continued weakness.


Source: Caterpillar.

Is this short interest warranted?

  • On one hand, the company's impressive results in its construction segment would say you're nuts to bet against Caterpillar. In the first quarter Caterpillar, behind strong cost controls and an improved construction market outlook, boosted its full-year construction sales growth forecast to 10% from a prior forecast of 5%. Conversely, Caterpillar's mining business, which makes up a considerably smaller portion of its revenue than it used to, remains notoriously weak. The answer really comes down to your timeframe. If you're a long-term investor then Caterpillar's pricing power, geographic diversity, and ability to cut costs should help move shares to the upside. Over the near-term, even with the boosted construction forecast there's a chance that higher lending rates from the wind-down of QE3 in the U.S. and political tensions from Ukraine and Russia could disrupt Caterpillar's growth potential.

AT&T
Why are investors shorting AT&T?

  • For such a dominant telecom company it might seem confusing as to why short-sellers have been piling into AT&T. The answer is actually simpler than you might imagine. Pessimism has built up primarily because AT&T is a defensive stock whose share price simply won't keep up with the overall move of the market higher. In other words, investors have been selecting riskier stocks (the risk-on trade), which has helped to stymie AT&T's share price and push it slightly lower over the trailing 12-month period. As long as the Dow keeps racking up new highs it's possible AT&T's short interest will continue to build.


Source: AT&T.

Is this short interest warranted?

  • With the exception that AT&T is having to ramp up infrastructure spending in order to catch up to its rival Verizon in terms of 4G LTE-capable cities, AT&T looks like a strong contender to outperform over the long run. AT&T has the most loyal customers according to research firm Brand Keys, which can translate into lower churn rates and higher quality margins. In addition, 80% of postpaid subscribers in its latest quarter had a smartphones, and data plans associated with smartphones have beefier margins. Having a premium yield of 5.2% as well as predictable cash flow makes AT&T a company most short-sellers should avoid.

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