Why These 3 S&P 500 Stocks Are Drawing a Lot of Heat

Is it hot in here, or is it just the S&P 500 (^GSPC 0.73%)?

I've lost track of just how many new all-time highs the broad-market index has rattled off this year, but I do know we're healthfully into the double-digits.

The S&P 500 closed within a stone's throw of the psychological 2,000 point level this week on the heels of another fantastic employment report. As noted by the U.S. Labor Department yesterday, 288,000 nonfarm payroll jobs were created in June, the fifth straight month above 200,000, and those helped push the U.S. unemployment rate down to 6.1%. Many economists would tell you that 4%-6% unemployment is fairly common for the U.S. economy, so we're very much near a normal historical range for the unemployment rate.

In addition to the jobs picture improving, housing prices in the 20 largest U.S. cities have moved higher by double-digit percentages according to data from Case-Shiller. Also, lending rates remain near historic lows, hourly earnings and consumer spending are on the rise, manufacturing activity is expanding robustly, and consumer confidence is at its highest levels in years. In other words, there's plenty of tangible evidence for optimists to latch onto.

Source: Rian Castillo, Flickr.

By a similar token, there's also a lot of evidence for pessimists to grab onto which could signal the market is nearing a tipping point. For example, while a majority of S&P 500 companies are topping EPS estimates, only around half are managing to hurdle the Street's revenue expectations. Instead of growing organically, a number of companies have chosen to repurchase their own shares and streamline their operations through cost-cutting in order to offer the perception of EPS growth. This type of move is often profitable in the short-run, but is rarely a long-term solution.

Also, the wind down of QE3 coupled with the Federal Reserve's plans to begin boosting lending rates in 2015 could cause loan activity to grind to a halt. This would be detrimental to the housing sector, businesses that are tied to the housing sector, and other interest rate sensitive big-ticket suppliers.

Keeping these concerns in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's three most hated stocks – in essence the three companies that are drawing the most heat from short-sellers. 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 three most hated companies:

Source: S&P Capital IQ.

GameStop
Why are investors shorting GameStop?

• You might best describe the bet against GameStop as a bet in favor of video game digitization. GameStop, while pushing into mobile and streaming game platforms, is still largely a bricks-and-mortar company. The expectation from investors is that as gamers move away from physical games and more toward convenience, GameStop could be on the outside looking in. Also, the release of next-generation consoles from both Microsoft and Sony pushed GameStop's sales through the roof recently. But, given that it took eight years to develop these new consoles it'll be practically impossible for GameStop to match its lofty same-store sales growth over the coming year.

Source: GameStop.

Is this short interest warranted?

• On one hand, video game sales continue to remain strong as is evidenced by marketing research firm NPD which noted that hardware, software, and accessories sales for the gaming sector rose by 52% year-over-year in May. GameStop also boasts incredibly strong cash flow and is generally inexpensive relative to the long-term challenges that it's facing. Then again, new console euphoria is likely to die down soon, which could give way to streaming game providers and push GameStop to the backburner once again. I don't view GameStop as a particularly strong short-sale opportunity given its strong cash flow, but I can certainly relate with pessimists that skepticism is merited.

Joy Global
Why are investors shorting Joy Global

• Unlike GameStop, the bearish case against heavy duty mining equipment provider Joy Global is as plain as day. With commodity prices well off their highs from a few years prior, and mining companies rolling back their spending until commodity prices once again work in their favor, Joy Global has seen orders for new mining equipment fall. Pessimists here are focused on the ongoing weakness in coal prices as well as the unwillingness of many gold miners to build-out new mines or expand existing operations. The idea here is that until commodity prices stabilize, orders for Joy's equipment will remain pressured.

Source: Terinea IT Support, Flickr.

Is this short interest warranted?

• Based on the company's second-quarter earnings results released four weeks ago, I'd say some degree of skepticism is warranted. Net sales for the quarter tumbled 32% to $930 million, though total bookings only dipped 7% to $1 billion. Joy continues to have good success with surface mining operations and service-based revenue, but original equipment sales to any expansionary underground mining activity is practically nonexistent.  While I do believe the company is set up for success over the long run, I really don't understand the basis of its recent share price run-up and would suggest, at least in the interim, that short-sellers are more likely to be vindicated.

ADT
Why are investors shorting ADT?

• Home security specialist ADT has been a fixture in the top five most short-sold S&P 500 stocks since early this year when its first-quarter earnings results failed to impress. During that particular quarter (reported in January) ADT's margins dipped and its revenue grew by a marginal 4%. Short-sellers have latched onto the company with the expectation that its pricing power is diminishing due to growing competition and high customer attrition rates, as well as the fact that it's toting around $4.4 billion in net debt on its balance sheet.

Source: Mr.TinDC, Flickr.

Is this short interest warranted?

• After missing the Street's estimates by $0.06 per share in Q1, ADT responded by topping EPS estimates by 0.06 in Q2. Although this is encouraging news, it also doesn't solve three of ADT's biggest concerns: namely its low single-digit growth rate, its high debt levels, and its high rate of customer attrition (most than 14%). Despite consumer confidence soaring, home security systems are among the discretionary items that consumers are most apt to part with if they feel the need to cut costs. With ADT appearing fully valued to me, I would suggest that it remains an intriguing short-sale opportunity.