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 rapid increases in the number of shares sold short and see whether traders are blowing smoke or their worries have merit.

Source: The Wall Street Journal.

Lacking Incyte?
A correction has swept through the biotech sector without being too discriminatory, and mid-cap Incyte was among the names punished by short-sellers. Shares have fallen from an intraday high north of $70 earlier this year to just $47.09 as of this past Friday -- a decline of one-third of its value.

Does this decline make sense? Few biotech stocks follow the usual standards of valuation, in that their pipelines and forecasted annual peak sales of leading therapies often comprise the lion's share of their valuations. For a company like Incyte, which is still valued at $7.9 billion even after a drop of 33%, yet is only expected to bring in roughly $466 million in revenue this year, the valuation alarm is bound to go off with certain traders.

Source: Incyte investor presentation.

The big question that investors need to ask themselves is whether or not a more potent, effective, and/or safer version of a myelofibrosis treatment will come to market, because at the moment JAK2 inhibitor Jakafi is a rapidly growing treatment preferred by physicians.

Are there alternative therapy possibilities? Absolutely, but it's going to depend on safety and efficacy as to whether or not they make it to market. The most unique alternative is Geron's (GERN 1.08%) imetelstat, which in an investigator-sponsored myelofibrosis trial actually produced a complete response in select patients. As a telomerase inhibitor, imetelstat actually offers the potential to treat the disease itself rather than just manage the symptoms of myelofibrosis, which is what JAK2 inhibitors like Jakafi do.

However, imetelstat's future is also clouded with a clinical hold currently in place as the Food and Drug Administration investigates persistent low-grade liver function test abnormalities that may or may not be reversible. Between a high dropout rate in its investigator-sponsored trial and these liver concerns, imetelstat may be off the radar before it has much of a chance to even get on. 

With that being said, Jakafi's projected 30% annual growth could easily put Incyte on investors' radars, especially with few new pathway MF drugs on the way -- but only if shares fall even further. Incyte's Jakafi does have all the makings of a drug that could deliver blockbuster sales potential, but waiting for a further pullback may not be such a bad idea.

Not so Qwikster
If you were among the 32.5% who increased their short position prior to April 30, you're probably in a world of hurt at the moment, with Netflix shares up around $100 per share in just a matter of four weeks.

Simply put, Netflix has been virtually unstoppable when it comes to attracting online streaming customers, and investors seem pretty excited about Netflix finally boosting the monthly subscriber rate by $1/month for new members. Netflix's digital library is practically unmatched, and the company, over the trailing four quarters, has added 12 million new streaming members. Furthermore, as the company has firmly switched from a DVD-rental business to a streaming model, its total margin (which it refers to as its contribution margin) following the initial drop has risen from just 7% in Q1 2013 to 15.6% in Q1 2014. In the upcoming quarter, Netflix expects this figure to improve to 18%.

Source: Netflix.

But, to echo one of the greatest corporate faux pas of all time, not so Qwikster, Netflix!

While it has forged key partnerships, allowing the company to reach more U.S. family-based households, Netflix is also reinvesting practically everything it's making back into its business. In 2013, for example, Netflix actually produced minus $17 million in free cash flow. That's a disturbingly bad number for a company that has added 12 million streaming subscribers over the trailing four quarters and which is now worth about $24 billion.

Let's also keep in mind that while Netflix may have name-brand leverage, many of Netflix's peers have deeper wallets, meaning they can just as easily snag media deals right out from under Netflix's nose -- or at least make Netflix work hard and pay more to secure them.

In other words, does the valuation really justify the means at this point in time? While I really don't see a better streaming alternative that has the deals in place that Netflix does, I also don't see much, if any, upside potential, with the company generating no significant cash flow. At some point the short-sellers are going to be right for more than just a few weeks, but it's also possible that trading in Netflix will stay irrational longer than short-sellers can stay solvent.

The waiting game
Lastly, clinical-stage biopharmaceutical company Keryx Biopharmaceuticals saw a double-digit percentage uptick in short shares held in late April, likely in anticipation of its key PDUFA date on its investigational oral ferric-iron based phosphate binder, Zerenex, as a treatment for hyperphosphatemia in dialysis-dependent patients with chronic kidney disease.

Why bet against Zerenex? We've seen enough instances of "buy the rumor, sell the news" in the biotech sector to last a lifetime, and Keryx shares have doubled over the past year following positive phase 3 results from Zerenex. Ultimately, bringing a drug to market is now only half of the battle. A number of therapies have stumbled out of the gate in recent years due to poor marketing, safety concerns, or being incorrectly priced. The assumption short-sellers are making here would be that Keryx would have to hit the nail on the head throughout the entire process to maintain its current valuation.

Then again, it can be tough for short-sellers to bet against an investigational drug that met both its primary and secondary endpoints in late-stage studies, and which is partnered with the highly experienced JTI/Torri in Japan. Over the four week assessment period Zerenex delivered a highly statistically significant reduction in serum phosphorous levels compared to the placebo (the primary endpoint), while also increase ferritin and transferrin saturation and reducing the need for IV iron and erythropoiesis-stimulating agents compared to the placebo (secondary endpoints). Long story short, and in English, Zerenex would appear to work well as a phosphorous-removing therapy, and could replace the current standard of treatment.

Perhaps the biggest problem of all is no one knows what to expect of Zerenex in terms of peak sales potential. I've seen figures thrown around from as low as $120 million in the U.S. to nearly $400 million. To add to the confusion, the Food and Drug Administration last week delayed its PDUFA decision on Zerenex by three months until Sept. 7. Although a delay isn't good or bad for Zerenex (i.e., don't read too much into the delay), it does mean another three-month launch delay if approved, and more cash burn for Keryx.

For now, I'm still suggesting you stick to the sidelines, as there are simply too many questions left to be answered, including whether Zerenex will run or limp out of the gate, if approved.