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 rapid increases in the number of shares sold short and see whether traders are blowing smoke or their worries have merit.

Source: The Wall Street Journal.

Two heads are better than one
Based on the recent upward move in senior living facility provider Brookdale Senior Living, Wall Street seems quite pleased with its $1.4 billion acquisition announcement of rival Emeritus (NYSE: ESC) last month. The deal, which also involves the assumption of $1.4 billion of Emeritus' debt, will help create a senior living company with 1,161 locations and representation in 46 of 50 states, which will control 10% of the senior housing market. 

Still, not everyone is a fan of the deal -- and for good reason. The Centers for Medicare and Medicaid Services has made it clear that long-term Medicare reimbursement rates are going to fall as the government looks to pare back businesses' reliance on government-sponsored plans to boost their bottom lines. For senior housing companies this means they'll need an influx of self-sufficient payers, or they could find it very difficult to grow their business organically throughout the remainder of the decade.

The good news here, though, is that the combination of Brookdale and Emeritus should result in a number of cost synergies as well as a $0.40 bump in EPS for Brookdale by the third year following the merger. It could also signal a wave of consolidation in the senior housing sector, as larger companies are going to be able to manage their costs better and have a more visible national presence.

I view the merger as a significant profit-booster and cost-saver for Brookdale, but I'm concerned that its current valuation may not properly reflect Medicare cut risks moving forward -- especially with Brookdale currently valued at 68 times forward earnings. Short-sellers may have a decent shot at being right over the short-term, but they may be steamrolled over the long run.

Steel of a deal?
Few battles between optimists and pessimists have raged on for a longer period of time in the industrials sector than that of steelmaker U.S. Steel, which still sports one of the highest short ratios within the S&P 500.

The bull case for U.S. Steel is that global steel prices are at or nearing a trough, which should bode well for steel manufacturers moving forward. U.S. Steel has undertaken aggressive cost-cutting measures, including idling and closing some of its production facilities in order to reduce global output and improve pricing. In addition, with U.S. Steel expected to be profitable for the first time in six years this year, investors believe that the forward valuation of 12 times earnings is simply too cheap to pass up once steel prices do begin to rise.

On the other hand, skeptics would point to the fact that while steel demand and pricing is improving in the United States, it's still very much up in the air for China and other emerging markets. It's quite possible that international steel producers might view the uptick in the U.S. as a reason to again flood the market with supply, which could work against U.S. Steel's margins. Finally, U.S. Steel's net debt of $3.3 billion makes strategic moves difficult to execute and could compromise its ability to boost its dividend in any meaningful way even if its operations dramatically turn around.

Overall, I land among the skeptics on U.S. Steel. While it's clear that the company is benefiting from strict cost management, the potential for steelmakers to flood the market with supply and China's erratic growth prospects keep me hesitant on the sector as a whole. With U.S. Steel rallying strongly in 2013 I'd suggest that improved expectations are already baked into its share price.

Hardly losing its luster
Lastly we have gold miner Eldorado Gold, which has drawn a 48% increase in short shares over the past two weeks of February as gold prices rebounded aggressively on geopolitical tensions in Crimea between Russia and Ukraine.

Short-sellers remain bearish on gold given that U.S. inflation remains tame and the need to pump liquidity into the U.S. economy via QE3 is beginning to taper down. With less chance of inflation on the horizon and the global economy remaining on the mend, the upside prospect for gold appears limited to skeptics.

However, Eldorado also offers some clear advantages that appear to put it above your average gold miner. For starters you get incredible geographic diversification, with mining operations in Turkey, China, Greece, Brazil, and Romania. All of these countries offer favorable labor expenses for Eldorado which help keep its costs down. Most importantly, Eldorado's costs are among the best in the industry, with total cash costs per ounce dipping $3 to $551/oz. in 2013 and all-in sustaining costs expected to be in the range of $915/oz.-$985/oz. in the upcoming year. In other words, it would take a steep drop in gold prices to really impact Eldorado's cash flow. 

While I do agree with pessimists that certain headwinds do exist for gold, Eldorado's improving production prospects and impressive cash cost controls make it an attractively priced gold-miner in my eyes.