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.

Plagued by Obamacare?
Surprised to see CVS Caremark, one of the nation's largest pharmacy-operators, among the companies with the biggest increase in short interest? I'm not, given the struggles we've witnessed so far relating to the launch of Obamacare's state and federal health exchanges.

Both CVS and peer Walgreen (WBA -0.11%) have rallied in anticipation of the launch of Obamacare. The optimism relates to the expectation that expanded Medicaid coverage and additional individuals purchasing health insurance should translate into more doctor visits and more prescriptions written. Walgreen has fought hard to improve awareness of Obamacare by partnering with insurer WellPoint, as well as handing out brochures in its stores, but it appears that both CVS and Walgreen are being done in by something completely out of their control: website glitches.

The glitches, which are currently keeping the majority of people from signing up for health insurance on the federal exchange, HealthCare.gov, could reduce lofty expectations built into drugstores like CVS. As a reminder, drugstore margins are typically razor-thin, and these businesses have had to turn toward loyalty rewards to improve customer retention in recent quarters. CVS needs Obamacare to be a success in order for its growth rate to return to the mid-single digits as Wall Street is forecasting.

As with the health insurance industry, I can see this being a short-term disappointment for CVS. But I feel that if investors are out to own this drugstore for the long haul, then its geographic diversity, household name, and impressive free cash flow are more than enough to work in optimists' favor.

OMG, S-H-O-R-T!
It has been an absolutely dismal back-to-school quarter for teen retailers. American Eagle Outfitters reported a 7% decline in same-store sales in the second quarter, higher-end teen retailer Abercrombie & Fitch delivered an 8% decline in comparable-store sales for the same period, and Aeropostale (AROPQ) really bombed with a 15% decline in comparable-store sales.

Why the frowny emoticons among teen retailers? For one, competition from department stores is intensifying as deep-pocket chains like Macy's bring in brand-name merchandise intended to appeal to teen consumers. This competition is causing the aforementioned trio of retailers to discount more heavily than they'd like to in order to attract consumers.

The other factor working against these retailers is simply the quickly changing fashion trends of teens. What worked last year may not work this year, and many teen retailers have been left with unfavorable inventory situations.

Yet despite these problems, I consider American Eagle Outfitters a potentially solid long-term play at these levels. American Eagle's management team has always had a knack for controlling inventory better than its peers, and its clothing is priced perfectly in between the high-end price point of A&F and the lower-end Aeropostale. With Aeropostale relying on heavy discounting to churn as much apparel as possible and A&F running into PR problems with some regularity, American Eagle lands perfectly in the middle, providing the consistency investors like to see.

American Eagle is also well capitalized, boasting $405 million in cash with no debt and a 3.3% yield. Between American Eagle Outfitters' cash on hand and operating cash flow, it's able to expand its business without going into debt like some of its peers.

In sum, this is certainly not a company I would personally consider betting against.

Insurance you can count on
Bet against Flo? Are you kidding me? Apparently, some traders would suggest doing just that, with short interest at the beginning of the month increasing by 27.6%.

On the surface I see two reasons why short-sellers would target Progressive here. One, low interest rates are plaguing the investment income portion of insurers' portfolios. Because of low interest rates, insurers like Progressive are being forced to settle for historically low bond rates, which are resulting in weaker-than-average investment-income returns.

The second reason has to do with Progressive's previous two quarterly reports (prior to its recently released third-quarter results), where it had missed Wall Street's expectations. Pessimists were clearly piling in prior to that report and counting on another earnings miss.

Although the first point still remains a viable reason for pessimists to be wary of insurers' profits moving forward, Progressive put its two-quarter earnings-miss streak in the rearview mirror this quarter. Net income did fall 16% due to lower investment income, but net premiums written advanced 5% to $4.45 billion and its combined ratio (a measure of margin insurers use to determine how profitable it is to underwrite policies) improved 170 basis points to 94.2% from 95.9%.

What short-sellers often forget is that property and casualty insurers like Progressive are cash-generating machines. Any time a catastrophe occurs that negatively affects Progressive's bottom line, it can simply use the catastrophe as justification to boost premiums. In other words, while there may be hiccups every now and then for insurers, so long as they remain conservative with their investment portfolio and cash reserves, they're likely to head higher over the long run.

Foolish takeaway
This week's theme is all about short-term emotions versus long-term business trends. Although each company offers clearly defined near-term headwinds that could stymie the share price, they also offer a catalyst for continued long-term growth that should make short-sellers think twice.