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 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 underperformed the Russell 3000, a broad-scope market index.

A large influx of short sellers shouldn't be a condemning factor for 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 number of shares sold short and see whether traders are blowing smoke or if their worry has some merit.

Source: The Wall Street Journal.

Ack, Man!
There are bad quarters in the retail industry, and then there's an entirely different category to which J.C. Penney currently stands alone. Since former CEO Ron Johnson's strategy to remove Penney's regular sales and install higher-end name-brand products in its stores, Penney's core customer has been fleeing en masse to its competitors.

The most obvious beneficiary has been Macy's (M +2.41%), which shares retail space in many of the same mall locations as Penney's and is now perceived by the public as the consistent value retailer of the two. In Macy's case, comparable-store sales are up 1.5% for the year, despite the company's missing EPS expectations in the second-quarter -- its first such miss in 25 quarters! Don't be discouraged, however, as Macy's anticipates a stronger second half of the year should the weather cooperate.

Penney's, on the other hand, is the walking wounded. Even activist hedge fund manager Bill Ackman whose hedge fund, Pershing Square Capital Management, owned an 18% stake (39.1 million shares) in the company, decided to pack his bags and move on despite a hefty loss.

We have seen some very moderate signs of improvement with same-store sales dipping by just 11.9% in the most recent quarter as opposed to a six-quarter average drop of more than 21%. Still, sequential comparable-store sales fell by 470 basis points and serves as a stark reminder that Penney's hurt its relationship with its core customer last year and they don't appear very willing to come back.

In short, don't stand in front of a moving vehicle that doesn't have brakes. Until Penney's shows concrete signs of improvement, stick to the sidelines.

Perrigo or no?
On paper, almost anything in the health-care sector looks like it should benefit over the long run. Perrigo is an over-the-counter and generic cold and allergy-drug maker, as well as infant formula supplier, that has stealthily built itself up to an $11.4 billion market value with few investors noticing. Supplying its products to some of the nation's largest retailers (e.g., Wal-Mart and Walgreen), Perrigo tends to see steady sales growth since consumers love the good deals that generic and over-the-counter medications offer relative to the price of physician prescribed medication.

The truth of the matter, though, is that Perrigo shareholders aren't living in a perfect world. In the company's fourth-quarter, for instance, Perrigo reported a 16% increase in sales to $967 million and guided its fiscal 2014 EPS to a range of $6.35-$6.60. That sounds pretty decent to me, but it fell short of the approximately $1 billion in fourth-quarter sales and $6.66 in EPS that the Street had been forecasting. In spite of the double-miss, which Perrigo blamed on weaker infant formula sales in China relating to a labeling issue, sales are still growing healthfully by double-digits and Perrigo has a deep pipeline thanks to its focus on generic and private labels.

The real concern I would have were I a Perrigo shareholder would be its pending integration of Elan (ELN +0.00%). The deal, which was announced in late July, allows Perrigo to purchase Elan for $8.6 billion, or $16.50 per share in a mixture of cash and stock. The deal is fantastic for Perrigo from a tax perspective since the Ireland-based Elan pays just 12.5% in corporate taxes. However, I can't help thnking Perrigo may have overpaid for Elan given its lack of current pipeline innovation. With the sale of the global rights of Tysabri to Biogen Idec for $3.25 billion and the failure of experimental Alzheimer's therapy bapineuzumab in late-stage trials, Perrigo is getting a nice sum of Elan's cash but is also taking on quite a bit of risk pipeline development risk.

This might be a case where sticking to the sidelines is the smartest thing to do until a few quarters following this buyout.

Pumping up the profits
I'll freely admit that I've had a hard time getting excited about natural gas drillers' valuations over the past couple of years. Although natural gas prices have rebounded well off their 2012 lows of less than $2 per thousand cubic feet, costs of production for many, or simply the capital expenditures needed to switch their production from gas heavy to a more balanced mix of liquids and gas, hasn't exactly opened the floodgates for value investors.

One such case is Cabot Oil & Gas, which is relying heavily on an increase in natural gas demand, and rising nat-gas prices, to drive its results. Yet again, on paper almost any company which is pulling fossil fuels out of the ground makes strategic sense since the demand for energy is only going higher. Yet Cabot's forward P/E of 29 and price-to-sales of 11 are enough to given any fundamentally driven investor a case of skittishness -- I know it certainly did that to me!

However, whatever skittishness may have existed is probably long gone following Cabot's second-quarter results. The company noted a 52% increase in production to 95.2 billion cubic equivalent feet of nat-gas as comparable-quarter costs fell 28% year-over-year and net income increased by nearly 150%! What I find more impressive is that Cabot's discretionary cash flow improved 109% to $297 million, proving that it can rely on its cash flow to fund its drilling programs. A truly pitiful $0.01-per-quarter dividend does leave a lot to be desired from a shareholders' perspective, but the stock appears unlikely to see any major downside unless nat-gas prices seriously tank.

Foolish roundup
This week's theme is all about differentiating between paper profits and the real world. On paper, Penney's has the right plan to turn its business around, Perrigo is going to see its business grow as baby boomers age, and Cabot is going to improve production as natural gas prices rise. In reality, Penney's ship is still taking on water (just at a slightly slower pace), Perrigo picked up a big question mark in Elan, and Cabot is at the mercy of nat-gas prices.