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, between 1983 and 2006, even with dividends included, 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 indicating 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.

Battleship sunk?
Shares of network connectivity components manufacturer Emulex have seen a huge spike in short interest recently as a combination of earnings weakness and technical action have combined to attract short-term pessimists. Just last week, for instance, Emulex announced that it would be laying off 10% of its workforce and closing an engineering facility as part of its cash-saving restructuring. Short sellers could very easily construe this as a sign of weakness in Emulex's business and all the more reason to place their bets against the company. 

On the other hand, though, Emulex shareholders don't have to look far to see how successful cost-cutting measures can be when combined with a growing need for connectivity components. Rival QLogic (QLGC), for example, recently completed its cost-cutting initiative that included job cuts in order to save $20 million annually. This is one reason QLogic was able to blow past Wall Street's EPS estimates in its most recent quarter. Simply put, cost-cutting could do wonders for Emulex!

The other factor to consider here is that connectivity components suppliers are likely to benefit in a big way in 2014 as telecom spending begins to trickle down to networking component suppliers like Emulex. If Emulex's cost savings kick in around the same time that it sees what I suspect will be a sizable uptick in orders Emulex could be in a position to crush Wall Street's estimates.

With $104.9 million in cash, no debt, and a forward P/E below nine, I think short sellers are playing with fire!

An alternative way of thinking
I can completely understand why short sellers have begun to pile into electric utility NextEra Energy -- the company has had an incredible run higher in a year when utilities have been practically neutral and it also boasts a relatively large net debt position totaling more than $28.2 billion due to infrastructure investments. For a pessimist looking at this debt load, they would have to assume that few strategic moves are open to NextEra given its burdensome debt position.

Despite this, just like Emulex I see little reason for optimists to be worried about NextEra Energy over the long term. The reason NextEra boasts such a large amount of debt relates to its many alternative energy projects contracted throughout the years, which led it to commission its 10,000th MW of wind energy production last December, as well as add to an already impressive solar production portfolio. Relative to every other electric utility in the U.S., none produces as much energy through clean sources than NextEra.

What this does is set NextEra up for considerably lower costs than its peers over the long run while also helping stabilize electric costs for many of its customers. This means that even with a huge debt load NextEra can comfortably pay its shareholders a 3% yield while generating more than enough cash flow to cover future projects as well as make its interest payments and slowly lower its debt. With a growth rate that should exceed its peers over the long run, I'd say short sellers should be careful when betting against NextEra.

Pedal to the medal
The long-awaited event has finally come and gone: the government has sold its final stake in General Motors common stock for a $10.7 billion loss. Short sellers, anticipating this move, figured General Motors' share price would come under pressure from the sale, as well as a recent resurgence in Japanese automakers in China and within the U.S. markets. But, like the previous two examples, I feel short sellers are motoring along in the wrong gear here.

One factor to consider is that GM is doing a good job of turning the tables on Japanese automakers in China where anti-Japanese sentiment has curtailed sales. Although Japanese automakers have recently reversed course in China, it's really been a year for U.S. market share gains with GM showing 13% year-over-year unit growth in November and putting the company on pace to deliver 3 million vehicles by mid-December.

Domestically, the story is much of the same for GM with unit sales up 8.8% this year as its newly redesigned Sierra and Silverado are pushing sales higher. General Motors is working both sides of the aisle by appealing to truck buyers who generally can care less about fuel efficiency while also introducing more efficient compact car models to appeal to cost-conscious consumers.

Like the aforementioned companies, GM with its single-digit forward P/E of nine looks ripe for the picking, not the shorting!