Are There Buying Opportunities Among Popular Shorts?

Generally, I view stocks with strong short interest cautiously. With unlimited downside risk, short sellers do their homework, and have a history of identifying shortcomings (pun intended) in stocks before other investors. David Einhorn's calls on Allied Capital (NYSE: ALD) and Lehman Brothers, and Whitney Tilson's call on Palm (Nasdaq: PALM) are examples.

At the same time, pessimism about a company's future may be a buying opportunity. Significant share float sold short is a pessimistic signal for a stock. If the pessimism is unfounded, a diamond in the rough may make a good investment, and it may enjoy a price pop when short sellers cover.

To find stocks that might have this potential, I screened for the following:

• Significant short positions -- at least 15% of float
• Liquidity -- quick ratio above 1.5
• Fundamentals -- annualized sales growth of at least 10% over last five years
• Valuation -- forward P/E below 25 and price-to-free cash flow below 20

This yielded 20 stocks, including:

Source: Finviz.com, Motley Fool CAPS.

A children's apparel retailer, Gymboree is trading near its 52-week high. The company has no debt, and it has grown earnings despite a weak economy. With 953 retail stores and plans to open more, short sellers may be concerned about the company's ability to expand profitably.

NutriSystem disappointed investors with forecasts of a weak first quarter. Partnerships with retailers such as Walmart's (NYSE: WMT) Sam's Club did not perform as anticipated last year, and sales continue to struggle. But, with a stock price 47% lower than its December 2009 52-week high, a stable dividend yielding nearly 4%, and promising results from its product designed for diabetics, bright spots remain.

A maker of diagnostic tests, Quidel, benefited from the H1N1 flu in 2009. Neither the company nor analysts expect a repeat in 2010, but with several infectious disease tests and reproductive health tests, the company's well-being isn't dependent on a pandemic. While still not cheap, the stock is down 23% from a 52-week high set in September.

Under Armour plans to retool its running and training footwear. The uncertain payoff to this investment and valuation may have investors concerned. However, with revenue that has quadrupled over the last five years and a successful track record of category expansion, it's hard to bet against the company.

These stocks are not specific recommendations, and there are reasons to be pessimistic, but I would argue the level of short selling seems overdone. Given the fundamentals and valuation, there just might be a buying opportunity.

More Foolish views on fearful stocks and short selling:

• 5 Deathbed Stocks?
• These 5 Underdogs Are No Dogs
• For Banks, It's Been 800 Days of Christmas