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, 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 is off. 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.

Is there a hole in this donut?
Genuine turnarounds are few and far between in today's fast-paced market, but Krispy Kreme Doughnuts has defied the odds by downsizing to smaller locations domestically and expanding abroad into high-growth regions like Latin America and Asia. Krispy Kreme is also trying to do its part by supporting shareholder interests with the announcement of a $50 million share repurchase program in July. The question now is whether or not Krispy Kreme's valuation has come too far, too fast.

While I'd certainly be a bit gun-shy about betting against the strength of the Krispy Kreme brand, on valuation alone short-sellers could have some ground to stand on. Krispy Kreme is currently valued at 32 times forward earnings but is only expected to deliver an average sales growth rate of 8% over the next two years. Its push into foreign markets will help drive sales higher, but it also needs to account for the learning curve in adjusting to new palates and different cultures. Not every venture overseas will be a success, which makes this valuation potentially frothy.

My other concern here would be Krispy Kreme's use of $50 million for share buybacks, especially with the stock near a new 52-week high. Historically, buybacks announced near a 52-week high across all stocks haven't worked out well for shareholders, and I would much rather have seen the company institute even a small quarterly dividend. Krispy Kreme has done well paying off its long-term debts, but I can't say I much approve of its recent cash usage.

With that in mind, I could certainly see short-sellers exerting their force on Krispy Kreme's share price and possibly pushing it lower in the interim.

Competitive struggle
The story has been somewhat similar for prepaid-debit-card company Green Dot, which rebounded from last year's 60% cliff dive and is up around 70% year to date.

The bullish thesis behind Green Dot revolves around America's growing usage of prepaid debit cards. Since the recession, the credit ratings of countless people have been tarnished due to financial woes relating to late mortgage or credit payments. For this group of people, prepaid debit cards are really their only banking option. With high-margin fees and a handful of large retail partnerships, Green Dot has excelled in delivering double-digit percentage earnings beats in four straight quarters. The big question is whether or not it can keep the good times rolling.

Just two weeks ago Janney issued a rare "sell" rating on Green Dot, downgrading the firm on increasing competitive prospects. Specifically, Janney singled out American Express' (AXP -0.26%) hard push into new retailers with significantly lower fees and free card reloads that could put some of Green Dot's business at risk. Just this past week I cautioned investors to ignore analyst ratings, as they rarely have any bearing on our long-term investing thesis. This, however, could be one of those instances where caution should be exercised.

Although Green Dot should have moderate success based on a surge in prepaid-debit-card usage across the country, it's also been highly reliant on Wal-Mart in years past for the bulk of its revenue. Green Dot has worked diligently to diversify its retail outlets beyond just Wal-Mart by expanding into CVS and Walgreen, but could struggle to keep up its recent growth rate with AmEx having a far larger cash position and the ability to undercut it in fees in order to gain market share. Yet again, short-sellers may wind up with the upper hand in the short term.

Cliff diving
Unlike Krispy Kreme and Green Dot, there hasn't been much of a rebound at all in hybrid branded and generic-drug developer Teva Pharmaceutical. In fact, short interest will probably only grow as the company marches closer to losing its patent exclusivity on blockbuster multiple sclerosis treatment Copaxone, which accounted for 22% of Teva's total revenue in the second quarter. In this case, the question short-sellers should be asking is whether Teva's loss of Copaxone will severely impact its share price or if branded and generic growth can cover Copaxone's loss in a matter of roughly two years.

On one hand, I can certainly understand where short-sellers are coming from, given that generic competition will likely slash sales of Copaxone by 90% within the first two years. That alone could mean more than a $4 billion sales reduction. Although this won't affect Teva's ability to stay profitable, it does put a big kink in Teva's cash flow machine, which is what fuels its branded and generic drug development. Momenta Pharmaceuticals (MNTA), in conjunction with Novartis' generic powerhouse Sandoz, is waiting in the wings with a generic version of Copaxone that, based on a partial patent-invalidation earlier this year, could clear the way for generic Copaxone to hit the market by as early as May 2014.

But there's another side to Teva that investors seem to have completely forgotten about: its generic-drug business. Teva has more than 1,000 molecules in its product portfolio and, due to its generic operations, never has a shortage of expiring drug patents to go after. Even though generic drugs have weaker margins than branded drugs, the sheer volume and scope of Teva's portfolio more than makes up for those smaller margins.

This is looking like a case where Copaxone's patent expiration has already been priced into Teva's valuation, and it could easily surprise investors to the upside going forward.

Foolish roundup
This week's theme is really all about understanding your competition. In the case of Green Dot, having its fees undercut by a much larger competitor could be a problem, while Krispy Kreme's biggest challenge will be understanding the differing cultures in the overseas markets it's entering. For Teva, though, it's the competition that should be quaking in its boots, given Teva's enormous and growing pipeline.