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 condemning 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.

A TMFULOI breaker?
For those of you not familiar, roughly four months ago I developed my very own overvaluation index known as the TMFUltraLong Overvaluation Index, or TMFULOI -- which, up until now, has been a very good indicator of companies poised to head lower. You can see for yourself how my index works, but also understand that it isn't without its flaws. As my colleague Rick Munarriz pointed out, it completely discounts rapid growth rates -- and IT-management software company SolarWinds looks as if it could be the first company to really "beat" my index.

For the second quarter, SolarWinds reported a 39.7% increase in sales and just a 31.4% increase in expense, as license and maintenance revenue both jumped an eerily similar 39.7%! More importantly, net income rose 51% while net margin increased 260 basis points.

Still, I remain steadfast in my original assessment that SolarWinds is grossly overvalued. Based on the median point of the company's upcoming growth forecast of 22% to 27%, that places the company at a PEG ratio of 1.5, with a price-to-cash-flow of nearly 32. With growth rates slowing, who's going to pony up 37 times forward earnings for this stock? Not this guy, that's for sure!

A crown of thorns
If I had it my way, Burger King would be doing a lot better than it is now. Since being taken private by 3G Capital Partners and re-emerging as a publicly traded company, Burger King has managed to lose its No. 2 spot in burger sales to Wendy's and has fallen even further behind all of its peers in the United States. Burger King had been focusing on expanding its international base but somehow forgot that the majority of its sales come from the U.S. -- go figure!

The company is attempting to play copycat by using some of the healthful-food trends and menu additions that McDonald's (NYSE: MCD) has used to move nutrition-hungry consumers through its doors, but it's light-years behind everyone else. Also on the menu is a fresh look for many of its stores. A freshening up of its storefront worked wonders for McDonald's and has turned Jack in the Box's numbers around, but I have to wonder whether there's any room for market-share gains from Burger King. Where's the differentiation and the motivation to head to Burger King? By the look of things, I'd say the shorts are having it their way!

Kid-tested, techie-approved
Who said Apple (Nasdaq: AAPL) was the only company set to corner the tablet market? LeapFrog Enterprises, in its most recent quarter, reported a 153% increase in multimedia sales (i.e., its kid-geared tablet known as the LeapPad), with total sales of all products in the U.S. nearly doubling. This growth seems unlikely to wane anytime soon, with LeapFrog's tablet price of $100 undercutting basically all of its tablet peers, and parents being completely willing to pony up the cash to educate their children.

As I highlighted in July, when I proclaimed that LeapFrog's run might just be beginning, it won't be without its own set of challenges. One of LeapFrog's key strategies is to develop an app-based system on its LeapPads geared toward kids -- a move very similar to how Apple has built its app-based empire. LeapFrog CEO John Barbour did note, however, that direct competition from Google's Android operating system could thwart its plans.

If LeapFrog can execute on its long-term goals and continue to push its LeapPad -- which, in turn, should remove the cyclicality of its business -- then short-sellers could be standing on the wrong side of the tracks when all is said and done.

Foolish roundup
This week's trend is, well, trends! SolarWinds is growing rapidly, but that growth trend is poised to slow over the coming years while Burger King's U.S. sales have been on a multiyear decline. LeapFrog, on the other hand, has seen sales of its LeapPad explode. These trends, at least to me, dictate how short-sellers should be reacting to these companies.

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

• Add SolarWinds to My Watchlist.
• Add Burger King to My Watchlist.
• Add LeapFrog Enterprises to My Watchlist.