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 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 their worry has some merit.

Source: The Wall Street Journal.

Going out of fashion?
If there's one thing about the retail sector that's fairly constant, it's that there will always be cyclical ups and downs within the industry. Consumer buying habits and fashion trends change, meaning apparel retailers need to be nimble enough to make changes when a shift occurs in order to increase sales over the long run. For VF Corp., the company behind North Face, Wrangler, Vans, Lee, and Timberland, short-sellers are expecting this cyclical downturn to come sooner rather than later, with its share price having tripled in the past three years.

But are short-sellers right?

On one hand, pessimists have a point when it comes to VF's growth rate. The company is valued at 20 times forward earnings, yet is only expected to grow its top-line by 8% this year, for a PEG ratio of 2.5 -- a bit high for the retail sector, and especially high for a company fueling its growth through acquisitions.

Then again, VF has given short-sellers every reason to keep their distance. In October the company boosted its dividend by 21% to $1.05 annually, its 41st consecutive year of dividend increases. A company with a 41-year streak of dividend increases gives off a vibe of financially soundness, and should be able to keep short-sellers at bay.

Also, on the same day it reported its 21% dividend hike, it delivered a third-quarter report highlighting a 5% increase in total sales, 7% boost in international revenue, and 14% increase from its e-commerce platform. What could really drive VF, though, is its outdoor and action segment, which has tended to draw a more loyal and margin-friendly customer base.

It's clearly not going to be a walk in the park for VF with its current premium valuation, but I wouldn't recommend short-sellers bet against this company.

Running out of gas?
There's nothing quite like the boom-and-bust nature of the natural gas sector. Between the highly volatile underlying price of natural gas, the questionable methods that can be used to retrieve that gas (e.g., fracking), and the exorbitant debt mound exploration and production companies will get buried under in order to get their operations off the ground, every investment feels like it comes with a lot of finger-crossing on the side.

One intriguing way to play the sector that gives investors less exposure to the volatile tendencies of natural gas pricing is through midstream pipeline companies that handle the transport, treatment, and selling of natural gas, such as Crestwood Midstream Partners.

There are some clear-cut reasons why short-sellers have honed in on this company of late. Primarily, Crestwood has missed Wall Street's EPS expectations significantly in each of the past four quarters, and it's valued at what would appear to be quite the premium at 38 times forward earnings.

However, this doesn't take into account projections that revenue is going to double in 2014 and that its bottom-line profit may quadruple thanks to its merger, completed in October, with Inergy Midstream. Most importantly, though, Crestwood anticipates a 34% jump in EBITDA and 6%-10% growth in targeted distribution growth, meaning shareholders can anticipate another year of hefty dividends likely yielding upwards of 7%. 

With so much money being thrown at infrastructure in terms of pipelines and storage, midstream companies such as Crestwood look like the real winners of the U.S. shale gas boom. While short-sellers may get a jab in here and there, Crestwood's transformational merger should deliver literal and metaphorical dividends for shareholders for years to come.

Send it back to the kitchen?
Last, but not least, we have Darden Restaurants, the parent company of Red Lobster and Olive Garden, which has drawn the ire of short-sellers following three consecutive quarterly earnings misses.

The problems for Darden's most prominent chains are pronounced and are coming from multiple different angles. Labor costs are soaring, especially with the implementation of Obamacare, which could dramatically boost health insurance costs when the employer mandate goes into effect on Jan. 1, 2015. Darden had considered following in the footsteps of rivals like DineEquity (DIN 0.21%), which have pared back hours below the 30 hour full-time threshold to avoid any potential for Obamacare penalties, but Darden's management team preferred the value of familiar faces in its restaurants to drive traffic.

Food costs have also kept customers away from casual dining restaurants, causing its Olive Garden chain to boost promotional activity to draw traffic into its restaurants. Promotional activity does help drive business, but it has the effect of reducing interim margins. If Olive Garden isn't successful in generating repeat or add-on business then the promotion proves worthless.

Finally, Darden's restaurants are also threatening to fall behind those of its peers in terms of technological advancement. Both Brinker International's (EAT -0.33%) Chili's and DineEquity's Applebee's have installed or are in the process of installing tabletop tablets for customer orders. These tablets should help improve drink order time and speed along the customer's ability to pay more quickly, allowing restaurants to turn tables quicker. This could wind up being the difference that allows Chili's and Applebee's to pull away from Darden.

What can't be overlooked is Darden's premium 4% dividend yield, which is often enough to scare short-sellers away. However, equally scary are the wide EPS misses in three straight quarters. While restaurant diversity should help Darden pull through its slump eventually, I feel short-sellers could have the upper hand in the interim.