The Dow's 5 Most Hated Stocks

Higher and higher the Dow Jones Industrial Average (^DJI 0.01%) goes. Where it stops, nobody knows!

It has certainly been a year to remember for investors, with the average annual return in stock indexes over the past century ranging from 8% to 10% and the Dow Jones delivering year-to-date gains of 22.2% as of Friday's close, up nearly 3,000 points for the year.

Source; Thenails, Flickr.

Practically everything is going right on the economic-data front to sustain this rally. The U.S. Bureau of Labor Statistics reported yesterday that a much better-than-expected 203,000 nonfarm payroll jobs were created in November which helped push the unemployment rate down to 7%, a fresh five-year low. Furthermore, earlier this week the second estimate for third-quarter U.S. GDP jumped to 3.6% from 2.8%, signaling that low interest rates are doing their job of encouraging loans and business expansion. Finally, rising home prices and sustained low inventory levels by homebuilders have helped fuel a rebound in the housing industry and helped push some homeowners' mortgages back above water.

Despite this positive news, however, not everyone believes the market has any gas left in the tank to move higher. Skeptics would point to the fact that share buybacks and steep cost-cutting have been utilized by companies to mask tepid organic growth in order to push their share price higher. While this does work for a short time, it's not a long-term solution, and the threat of poor earnings cascading the Dow Jones lower is quite tangible.

With that in mind, I suggest we do what we do every month, which is to take a closer look at the Dow's five most hated companies -- in essence, the five stocks with the highest level of short interest – to better understand what characteristics, if any, are attracting short-sellers so we can avoid buying similar stocks in the future.

Here are the Dow's five most hated stocks:

Source: S&P Capital IQ.

Intel
Why are investors shorting Intel?

• The bet against chipmaker Intel by short-sellers hinges on the need by Intel to shift cash flow toward research and development to create products geared at the cloud and mobile devices. This extra spending on innovation caused by a rapid fall-off in PC sales has stymied Intel's bottom line growth and made its revenue growth in the interim somewhat unpredictable. Short-sellers are counting on this weakness and uncertainty to drive the share price lower.

Is this short interest warranted?

• Based on Intel's most recent quarterly figures I don't think there's any question that short-sellers are justified in their pessimism with Intel's revenue coming in flat year-over-year as profits decline by less than 1%. However, we have to remember that the stock market is forward looking and rarely gives more than a few days credence to results that are in the past. Intel is making big strides in developing tablet-based processors and remains on target to derive perhaps up to 30% of its revenue stream from the cloud by 2020. Intel will certainly deal with its cyclical peaks and troughs as all semiconductor companies do, but between its impressive cash flow and 3.8% yield I don't feel short-sellers are wise to be betting against Intel here.

Caterpillar
Why are investors shorting Caterpillar?

• Now if you want a company that's been sending short-sellers all the right signals, look no further than heavy construction machinery manufacturer Caterpillar which has lowered its revenue and EPS outlook not once, not twice, but three times this year alone. Caterpillar has been hit hard by a steep drop-off in commodities prices which mean lower revenue for mining companies and thus fewer new orders for Caterpillar. 

Is this short interest warranted?

• Of the Dow's 30 components, there's probably not a company more deserving of higher short interest than Caterpillar, in my opinion. Caterpillar's management has stated that visibility over the next few years is poor and it's not exactly certain when the commodities market will turn back in its favor. Even though I'm personally bullish on commodities, I foresee the potential for ongoing earnings warnings, especially with the potential for commodity-based weakness when the Federal Reserve begins paring back QE3. I'd let the short-sellers have their way with Caterpillar for the time being.

Verizon
Why are investors shorting Verizon?

• Unlike Intel and Caterpillar, you might consider it a bit odd to find Verizon, which is having no bottom-line or top-line concerns, among the most short-sold stocks. The reasoning is actually much simpler than you might imagine. Telecom service providers like Verizon are typically defensive plays that bring in consistent cash flow regardless of the economic environment. With a near-necessity business and low volatility it's being left in the dust by higher growth stocks amid this rally. In other words, Verizon just isn't high-growth enough to hang with this rally and short-sellers are pouncing on that fact.

Is this short interest warranted?

• I'm actually confused as to what short-sellers hope to accomplish by betting against Verizon which is a low volatility stock, selling inelastic and high demand products (phone, Internet, and television), and paying out a healthy 4.2% yield. That yield alone should be enough to scare most short-sellers away. I can possibly see some angst over its massive $130 billion purchase of its remaining Verizon Wireless from Vodafone, but this purchase should be smooth since it's just joint ownership changing hands. To sum up, I wouldn't even consider betting against Verizon here.

AT&T
Why are investors shorting AT&T?

• In addition to encountering the same objections as Verizon above with regard to top and bottom-line growth lacking during this explosive rally, AT&T is also being forced to spend heavily in order to catch up to Verizon which has more 4G LTE capable cities than its other three domestic peers combined. With a somewhat boring business model and slow sales growth short-sellers are counting on traders to cycle out of AT&T shares and into something with more risk and growth potential, theoretically sending shares of AT&T lower.

Is this short interest warranted?

• Just as I said with Verizon, I'm not quite sure what short-sellers would see in AT&T in the first place. I can somewhat understand the skepticism surrounding its $1.2 billion Leap Wireless purchase which I think AT&T brutally overpaid for, but AT&T's brand-name and inelastic product line-up is strong enough that it can survive a poor management decision every now and then. With a premium dividend to Verizon at 5.1%, I'd suggest short-sellers keep on walking.

Visa
Why are investors shorting Visa?

• The way I see it, there are two reasons in particular why investors would even consider betting against payment processor Visa. First, they could be bearish on its near-term growth following the Dodd-Frank provision which caps debit swipe fees at $0.21 per transaction. With an upper boundary on debit card profitability, short-sellers are expecting Visa debit-card growth to taper off a bit. The other factor at work here is the potential for a rough holiday season as indicated by the poor showing from retailers during the back-to-school shopping season. Lower spending could mean fewer transactions for Visa, and thus a less-than-impressive holiday season profit.

Is this short interest warranted?

• To quote myself from last month, sometimes "short-sellers are out of their minds." Visa is a global payment processing juggernaut that's likely to see double-digit growth potential from overseas markets for the next decade and beyond since much of the world is still processing transactions in cash. Furthermore, with limited liability as just a network processor Visa isn't subject to loan lending concerns, meaning it can simply focusing on bringing more merchants into its network. It's basically a perfect financial business model and a stock I would strongly suggest you don't bet against.