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 have tended to trend up over the long term. But when you look at individual stocks, you'll find plenty of stocks that lose money over the long haul. According to hedge fund institution Blackstar Funds, even with dividends included, between 1983 and 2006, 64% of stocks -- nearly two-thirds -- underperformed the Russell 3000, a broad-scope market index.

A large influx of short-sellers shouldn't be a damning factor to any company, but it could be a red flag from traders that something may not be as cut-and-dried as it appears. Let's look at three companies that have seen a rapid increase in the amount of shares sold short and see whether traders are blowing smoke or whether their worry has some merit.

Source: The Wall Street Journal.

Short-sellers bet on red
Planes are a nuisance, Las Vegas is hot, and vacations are expensive -- and that could be great news for International Game Technology. IGT is already responsible for making the software that goes into casino slot machines, but it and Bally Technologies (NYSE: BYI) obtained the first two online gambling licenses in the U.S. in June. The way I see it, IGT has cleared the first set of hurdles, but it remains a mixed bag of prospects and problems.

On the bright side, in June, IGT purchased online gaming application DoubleDown Casino, the most popular gaming app on Facebook. DoubleDown allows IGT a platform to offer a free version of its Da Vinci Diamonds slot-reel game and target DoubleDown's 5.2 million unique monthly visitors. Of course, the bread and butter here is IGT's potential to eat into global online gambling income, which reached $32.8 billion in 2011.

Conversely, the short life cycle of gaming technology requires constant innovation and spending. Macroeconomic factors also affect gambling revenue. As long as unemployment rates remain high and wages depressed, gambling revenue will remain subdued. Finally, there are no assurances that IGT will receive final approval to offer online gambling in the U.S. For short-sellers, this really could go either way.

Fly like an Eagle
With oil and natural gas exploration company Forest Oil hitting its lowest levels in 13 years earlier this month, you could say that short-sellers were very wise to be betting against the natural-gas-heavy company. As for me, I've been on the wrong side of this trade -- at least in my CAPS portfolio. Despite short interest in excess of 20%, I feel now is as good a time as any to consider investing in Forest Oil.

Like other natural gas producers, Forest is focused on reducing capital expenditures, increasing its higher-margin liquid output, and divesting noncore assets. Forest plans to reduce its rig count in the Panhandle region to just two from its current five and remove one of the two rigs it has operating in East Texas in order to halve spending in the second half of 2012.

Recent drill results have also indicated that Forest should be able to dramatically boost production in the lucrative Eagle Ford Shale, an asset base that essentially holds the key to Forest's success (as well as lucrative oil reserves). Estimates from Forest are for net volume to triple to 3,000 barrels of oil equivalent per day by year's end from the 1,000 Boe/d it produced in its latest quarter. With the International Energy Agency predicting a 1 million barrel per day increase in oil usage next year, oil drillers like Forest should be looked at as value plays, not short-selling opportunities.

Drill, baby, drill!
When my Foolish colleagues Travis Hoium, Alex Planes, and I kicked off our weekly analyst debates in March by discussing Seadrill, I was the lone voice of dissent. Back then, I argued that high debt levels and an unnecessarily high dividend payout made the company unattractive and downright risky. Four months later, I can safely say that those risks are still very apparent.

One might call Seadrill almost reckless with the amount of leverage it employs. The upside to that is that Seadrill's fleet is the newest, most technologically advanced deepwater-capable fleet, period! On the downside, Seadrill is saddled with a seemingly insurmountable $10.2 billion in net debt. And what is this driller doing with its operating cash flow? Paying out an exorbitant 8% dividend yield that's throwing the company heavily into free cash outflow status! In fact, Seadrill has had a cash outflow in more than 80% of its quarters over the past six years!

Despite its legal woes, I much prefer Transocean (NYSE: RIG). Its decision to sell 26 million shares in a secondary offering to shore up its balance sheet back in November was unpopular, but it gave the company a far safer financial position with equally strong earnings prospects when compared to Seadrill. Short-sellers, you can have Seadrill.

Foolish roundup
This week, the main theme was "You don't score until you score." IGT, SeaDrill, and Forest all show incredible promise, but right now only Forest's Eagle Ford Shale provides the impetus that could send it higher. Seadrill's debt and IGT's need for further licensing aren't enough for me to think they'll head higher.

What's your take on these three stocks? Do the short-sellers have these stocks pegged, or are they blowing smoke? Share your thoughts in the comments section below and consider using the links below to add these stocks to your free and personalized watchlist to keep up on the latest news with each company.

Also, if you'd like to avoid the potential pitfalls that high short interest can bring, I suggest you download a copy of our special report: "The Motley Fool's Top Stock for 2012." In it, our chief investment officer gives you the skinny on a company he has dubbed the "Costco of Latin America." Best of all, this report is completely free, but only for a limited time. Don't miss out!