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 if their worries have merit.

Source: The Wall Street Journal.

Do-it-yourself back on the shelf?
It's been more than four years since there's been any semblance of worry on the faces of Home Depot shareholders, but following the company's first-quarter earnings release about six weeks ago, those fears have been steadily manifesting in a growing short position.

For the first quarter Home Depot reported a 2.9% increase in sales to $19.7 billion as global comparable-store sales rose by 2.6%. U.S. same-store sales were up a slightly more robust 3.3%. For the full year Home Depot reaffirmed its forecast for 4.8% sales growth but eased off its EPS projections ever so slightly to a new EPS forecast of $4.42, representing a 17.6% year-over-year increase.

Source: Mike Mozart, Flickr.

Like most companies, Home Depot found its business hurt by the colder-than-expected winter, which pushed interior and exterior home improvements out further than some consumers had planned. Pessimists took this as their cue to bet against Home Depot shares, but it may not make much sense as a long-term bet, considering the weather is unpredictable and customer orders will simply be pushed down the road a quarter or two.

The more pressing issue that investors should be monitoring is the Federal Reserve's stance on interest rates. With the expectation that rates will begin rising in 2015, the demand for new home purchases could quickly dry up. We've already witnessed ample evidence that consumers are hypersensitive to interest rate swings based on the sizable drop in weekly loan originations from the Mortgage Bankers Association's weekly data release, so a drastic dip in home sales isn't out of the question. A dip here could adversely affect Home Depot's U.S. commercial business.

The good news is that Home Depot also has a solid residential customer base, and the home remodel market remains strong. If lending rates rise and "trap" consumers in their existing homes, remodeling is likely to increase. In other words, Home Depot continues to have a vertical hold on all aspects of the housing sector and is hedged to benefit one way or another. Once you tack on a healthy and growing 2.3% dividend yield you have all the reasons you need not to bet against Home Depot, in my opinion.

Rallying against rails
It was one of the most unpopular industries during the recession, but the railroad sector has been unstoppable since 2009.

Source: Kool Cats Photography, Flickr.

Union Pacific, the nation's largest rail network, grew its operating revenue by 7% during the first quarter on the heels of a 16% boost in agricultural product revenue and a 10% boost in industrial product shipments. In addition, Union Pacific has been actively hiring, a signal to investors that it anticipates more robust growth in the immediate future, and it recently boosted its full-year capital-expenditure forecast to $4.1 billion, which again implies strong near-term growth potential.

Of course, the way short-sellers view Union Pacific after a 300% run higher over the last five years is that it'll need to execute perfectly if it hopes to keep its somewhat lofty P/E of 21.

Consider for a moment that Union Pacific has no control over the weather, but that the weather can greatly impact its business. A summer drought can wreak havoc on agricultural transports, while a harsh winter has the potential to adversely impact nearly all consumer goods.

Commodity prices are another big point of contention for railroad operators. If commodity prices are sinking or stagnant, the allure of producers to increase production may not be there. This means potentially lower shipping volumes for Union Pacific.

The truth of the matter, however, is that Union Pacific's operation ratio (a measure of railroad efficiency) improved a full 200 basis points to 67.1% in its latest quarter. Union Pacific's management team understands that commodity prices for products like coal aren't working in its favor at the moment and it's done what it can to control costs. Also, Union Pacific's sheer size and fuel-efficient locomotive fleet gives the company a pricing power edge over many of its smaller peers.

While even I am skeptical of how high its share price can head, I wouldn't recommend short-sellers stand in the way of this runaway train.

Spinoff fever
Spinoffs have been a tool that a number of companies and sectors have used over the past couple of years in order to unlock shareholder value by giving investors a closer look at how different segments of a company earn their keep. Even the health care sector has witnessed its fair share of spinoffs.

Source: Kropekk_Pl, Pixabay

In early June Theravance (NASDAQ: THRX) separated from Thervance Biopharma in order to give investors a way to capitalize on the company's diverging product portfolio. Theravance retained the rights to a number of collaborative COPD medications that are FDA-approved and under development, essentially creating a royalty company with a $0.25/quarter dividend. The other company, Theravance Biopharma, is comprised of FDA-approved Vibativ and the remainder of Theravance's prior clinical and preclinical compounds.

While you'll get no dividend with Theravance Biopharma, the thought here is you'll have a considerably higher reward if any of its other pipeline products hits big. Of course, there's also the potential for significantly more risk.

When Theravance Biopharma was spun off I was a fan of both businesses, but following a 50% run in Theravance Biopharma shares in less than a month I can't say I share that same enthusiasm any longer. Although Theravance Biopharma has nine clinical phase products across a healthy number of indications, I'd much rather wait for a couple of these phase 2 studies to come in before suggesting this stock can head even higher. Keep in mind that Theravance Biopharma is likely to be unprofitable for the next couple of years, so this share price surge may be more emotionally charged following the spinoff than fundamentally based. As such, I'd suggest that short-sellers do have a reason to be skeptical here.