The S&P 500's 5 Most Hated Stocks

Those who waited for the S&P 500 (^GSPC -0.88%) to pull back in 2013 were sorely disappointed. For the year, the broad-based index tacked on nearly 30%, tripling its average annual return, as economic data improved, leading optimists to believe that this upward trend may still have legs.

Integral to the S&P 500's rally was a considerably stronger-than-expected third-quarter GDP report, which showed the U.S. economy grew by 4.1%. This third and final estimate was upped two times, demonstrating just how surprising the growth was to economists and investors. In addition, housing prices continue to recover, the credit quality of banks' loan portfolios keeps improving, and the U.S. unemployment rate is at a five-year low.

Despite these undeniable steps in the right direction, significant numbers of pessimists and skeptics still believe the market is ripe for a correction -- specifically companies within the S&P 500. At the heart of the short-sellers' argument is the fact that most companies are relying on cost-cutting, rather than organic product and pricing growth, to drive profits higher. Couple that with share buybacks, and you have an artificial way to make it appear as if a company is growing profit year over year. Unfortunately, this type of growth can only work for a limited time, which is precisely what the skeptics are counting on.

With that in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's five most hated stocks. Why, you ask? Because this way we can better understand what characteristics, if any, attract short-sellers so that we can avoid buying similar companies in the future.

Here are the S&P 500's five most hated companies:

Source: S&P Capital IQ.

Cliffs Northshore Mine, Source: Cliffs Natural Resources.

Cliffs Natural Resources
Why are investors shorting Cliffs Natural Resources?

• Another month gone by, and once again iron ore and metallurgical coal miner Cliffs Natural is the S&P 500 stock with the highest short interest. Cliffs has been a regular target of short-sellers for some time now because iron ore prices have been weak and steel demand low (met-coal is used in the steel-hardening process). This pricing weakness actually prompted the company to slash its dividend by 76% in 2013 in order to lower expenses. With few near-term catalysts, short-sellers are anticipating that weak iron prices could further hamper Cliffs' bottom line.

Is this short interest warranted?

• There's no question that some degree of skepticism is deserved for commodity-based companies at a time when nearly all commodity prices are down and China's growth is proving more erratic than ever. However, the worst is probably in the rearview mirror, and to me it appears unlikely that Cliffs will see significant downside moving forward. Iron ore prices have rebounded strongly over the last few months, and Cliffs also announced a labor agreement with U.S. steelworkers at its Pointe Noire operations in Quebec, which will certainly help reduce expenses. With cost-cutting on its mind and prices finally working in its favor, Cliffs could be in for a nice rebound in 2014.

U.S. Steel
Why are investors shorting U.S. Steel?

• Always a hot-button name on the short-sale side of things, steelmaker U.S. Steel has drawn the ire of pessimists in recent months by delivering a nearly 100% return since May despite ongoing losses, including a whopper of a goodwill impairment charge totaling $1.8 billion in the third quarter. Similar to Cliffs, a lack of clarity in steel demand from China, coupled with previously weak growth in the U.S. (prior to the third quarter, that is!), gave short-sellers ample cause to latch onto U.S. Steel and not let go.

Is this short interest warranted?

• Though I have been wholeheartedly in agreement with short-sellers in the past, my skepticism on U.S. Steel has begun to wane a bit. Prices, which have long been U.S. Steel's problem, have started to improve, while domestic demand could soar, with ISM readings in the U.S. running impressively high. If there's one factor that still turns me off to U.S. Steel it's the company's gargantuan debt load, which sits at $3.37 billion in net debt. This debt places U.S. Steel at a disadvantage to its peers when it comes to making strategic moves and could be enough reason to warrant this ongoing high short interest.

GameStop
Why are investors shorting GameStop?

• GameStop's emergence among the top-five most hated S&P 500 stocks has to do with its meteoric rise over the past year, fueled by the release of key new video game titles and next-generation consoles from Microsoft and Sony. Short-sellers are counting on a "buy the rumor, sell the news"-type event, in that much of GameStop's run-up was based on anticipation of new console sales. The expectation is that once these consoles go on sale the euphoria will dry up, possibly giving way to digital sales, where GameStop still lags behind its peers.

Is this short interest warranted?

• Based on GameStop's third-quarter results, it does look like the short-sellers could be primed for a strong second half of 2014 and beyond. For the quarter, GameStop delivered an 18.8% increase in global sales, as comparable-store sales (those stores open at least a year) rose a whopping 20.5%. The new release of Grand Theft Auto V was a big help, as were the releases of the Xbox One and PlayStation 4. However, GameStop would need nothing short of a miracle to keep these comps rolling into the second half of the year. With the latest console replacement cycle lasting six years, it's unlikely GameStop is going to see another year like 2013-2014 for, well, another four to six years. That doesn't mean GameStop won't continue to rake in strong cash flow, but maintaining its lofty valuation may be difficult.

Frontier Communications
Why are investors shorting Frontier Communications?

• The reason short-sellers have piled into telecom service provider Frontier Communications over the past couple of years dates back to its exorbitant purchase from Verizon of landline assets in 14 states. Because mobile-phone coverage has improved, the need for landlines has shrunk dramatically, adding to a steady stream of customer attrition on that side of Frontier's business. Pessimists are counting on Frontier to keep losing customers and for its high yield to be unsustainable over the long run.

Is this short interest warranted?

• In recent months I've been quite optimistic on Frontier's long-term outlook, but the mid-December announcement that it was purchasing AT&T's landline operations in Connecticut made me want to bang my head against the wall. The good news is that the deal brings in 415,000 new broadband subscribers. However, it creates a headache when it comes to trying to retain these landline customers. While I am still positive on Frontier thanks to what appears to be a sustainable 8.5% yield, this new deal does raise doubts that Frontier's focus is where it should be.

ADT
Why are investors shorting ADT?

• Unlike the previous four companies, the negativity surrounding electronic security company ADT isn't as readily apparent. I would propose that the reason short-sellers have piled onto ADT has to do with the way in which it is growing profits relative to its top-line growth. As I mentioned earlier, share repurchases have been a big earnings-per-share growth driver in recent quarters. In 2013, ADT repurchased about 5% of its outstanding shares, and, not surprisingly, EPS rose by 5.7%. In other words, with mid-single-digit sales growth ADT was only able to manage an increase in EPS because it repurchased shares. That's not too encouraging if you're a shareholder, but it's welcome news for pessimists.

Is this short interest warranted?

• This is a tough call, because there aren't exactly any blatant near-term catalysts that would send ADT to the downside, yet there's not much for optimists to be excited about, as the growth rate is a meager 4% to 5% and the company is using share buybacks more than anything to fuel its growth. If I were a shareholder, I'd take a wait-and-see approach and evaluate ADT over the next quarter or two.