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 isn't 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 if traders are blowing smoke or their worries have some merit.

Source: The Wall Street Journal.

Revolutionary or revolting? You be the judge!
There are few companies that can spark furious bull versus bear debates, and 3-D printing solutions provider 3D Systems is one of those controversial stocks.

On one hand, 3D Systems offers manufacturing and industrial companies a way to prototype new products more quickly, efficiently, and cheaply than was possible in years past. With the ability to make one-off prototypes rather than order a large batch, sectors from the auto industry to component producers in the aerospace and defense and oil and gas industries can test new designs quickly, and for minimal cost. Furthermore, as Foolish 3-D printing expert Steve Heller noted just this weekend, 3D Systems' technological superiority over its peer Stratasys (SSYS -1.11%) -- it holds seven different types of 3-D printing technologies while Stratasys boasts only two -- gives it perhaps the best long-term growth potential in the sector.

But there's also another side to this coin. To begin with, 3D Systems may have plenty of long-term potential to revolutionize the manufacturing sector, but that very well could be baked into its share price already, with the company valued at 64 times forward earnings and a whopping 17 times trailing sales. Secondly, 3D Systems is always going to be tied to the success of the manufacturing and industrial sectors, meaning its orders are likely to remain highly cyclical. Finally, I believe investors are underestimating how difficult of a time 3D Systems could have in incorporating the roughly three dozen acquisitions it's made over the past four years. Getting these businesses to blend isn't without its own set of "hiccups."

Ultimately, I believe 3D Systems is a game-changer, but I don't believe this current valuation reflects the aforementioned risks well. While it may be a bumpy ride, I suspect short-sellers could have the upper hand over the next couple of years.

Do I have a higher bidder?
Auction house Sotheby's might pre-date a number of generations on your family tree, but right now the auctioneer finds itself under a mountain of scrutiny from two activist hedge fund managers, Dan Loeb of Third Point and Richard McGuire of Marcato Capital Management, who expect big changes -- and perhaps board seats -- in order to enhance shareholder value.

The call for change comes at the right time, with Sotheby's reporting its fourth-quarter results after the bell on Thursday last week, missing the mark on both the top- and bottom-lines. For the quarter, revenue grew 16.5% to $339.2 million, aided most by strength in the global art market, as EPS of $1.30 expanded nicely from $0.96 in the year-ago period. Wall Street, however, anticipated $351.6 million in revenue and $1.40 in EPS. This miss reflects what Sotheby's described as a "competitive environment for high value consignments." 

In late January, Sotheby's introduced what it believed to be ample value-generating initiatives for investors, including a $300 million special dividend, and the authorization to repurchase up to $150 million in common stock. Loeb and McGuire, on the other hand, are looking for significantly more from Sotheby's. In fact, McGuire believes that Sotheby's could return $1 billion in capital to shareholders over the next year and still have more than enough to meet its long-term goals, according to a Reuters report. 

"Who's right?" you ask. In this case I believe the biggest factor working against short-sellers is that activist hedge funds are getting their way more often than not as of late. Yet working against optimists is the simple fact that the consignment auction business has never been particularly high growth. This means the big gains we've seen recently are probably unsustainable over the next couple of years. Overall, Sotheby's is fairly valued in my eyes, accounting for an expected slowdown in growth and a boost in shareholder initiatives. If it were to drop or spike considerably then I'd consider re-evaluating it again.

A clean slate
Finally, consumer goods giant Procter & Gamble appears to have drawn the ire of pessimists in increasing numbers since it reported its second-quarter earnings results toward the end of January.

For the quarter, Procter & Gamble delivered flat net sales growth including negative foreign currency translation, but we also witnessed 3% organic volume growth and a healthy 6% growth in its health care products volume for the quarter. More impressively, P&G stuck to its full-year forecast of 3%-4% organic volume growth and 5%-7% adjusted EPS growth.

For pessimists, the fact that P&G's growth is being constrained by negative foreign currency translation and the maturation of its business operations, yet trading for 17 times forward earnings, is enough to believe that the company will move lower. However, I would suggest that short-sellers could be the ones running for cover over the long run.

To begin with, the simple fact that organic volume was up this past quarter demonstrates that P&G has incredible pricing power around the globe. Not to mention the majority of P&G's product line is made up of necessity products, which are notoriously resilient to economic downturns.

Another factor to keep in mind is that Procter & Gamble is focused on investing heavily in emerging markets to find growth avenues while also ridding itself of non-core focus areas. As we noted just a week ago, the company is planning to divest its overseas bleach business since it doesn't fit with the company's theme of emphasizing its core products.

Finally, don't underestimate the importance of having A.G. Lafley back at the helm. After a four-year absence, the CEO who led P&G to greatness in the domestic markets is going to see if he can work his magic again on P&G's emerging market growth opportunities. With a 57-year streak of dividend increases under its belt and a tested leader running the company, I'd call short-sellers insane for even attempting to bet against P&G here.