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.

Fulfilling its potential?
On the surface, it looks like it's been rough sledding -- or should I say drilling -- for short-sellers in independent oil and natural gas driller Gastar Exploration. Shares of Gastar are up more than 200% from its 52-week low as the company's production has expanded -- total production jumped 43% in the first quarter from the year-ago period -- and it has finally turned the corner to profitability.

Source: Duggar11 via Flickr.

Of course, not everything has gone perfectly for Gastar, which is why short-sellers appear to have latched on recently. For example, Gastar has missed Wall Street's profit projections in each of the past four quarters and in seven of the past 11. Normally you can shrug off an earnings miss in a small-cap oil and gas driller as simply reflecting insufficient coverage on the company. However, there are 10 analysts following Gastar, so its latest miss was legitimately off the mark. If Gastar can't meet Wall Street's expectations, then perhaps its 200%-plus run-up isn't deserved.

The other factor pessimists have latched onto is its high concentration of gas production. In its first quarter, only 41% of its production was oil and natural gas liquids, with the remaining being natural gas. Natural gas prices are far more volatile than liquids, and if not hedged, could leave Gastar exposed to significant top and bottom-line downside.

But, on paper Gastar appears to be incredibly cheap, with consensus estimates placing the company at a mere 12 times forward earnings with a growth rate that should ascend past the double-digit percentage mark through 2018 by my best estimates. Even if Gastar's natural gas production is higher than that of its peers, the company has worked diligently to ensure that a good portion of its production is hedged against spot price fluctuations. In Q1, 77% of its natural gas production was hedged.  

Long story short, there could be temporary dips in Gastar's share price led by underlying commodity price swings and investors' own lofty expectations, but Gastar's improved production in the Marcellus Shale coupled with its potential in Oklahoma's Hunton Limestone make me not want to bet against this company.

Off the mark
Clinical-stage biopharmaceutical company Arrowhead Research has lost nearly 60% of its value since mid-March, and the headhunters are apparently out looking for more. Of course, investors should keep in mind that Arrowhead's run from July 2013 through March 2014 culminated in a 905% increase in its share price, so perhaps some pessimism was long overdue.

Arrowhead's claim to fame is its preclinical and clinical portfolio of RNAi gene-altering therapeutics. The company's lead drug is ARC-520, a treatment being developed to treat chronic hepatitis B that some analysts suspect could have blockbuster potential if approved. Arrowhead recently dosed two cohorts of patients in its phase 2a study of ARC-520 and will be looking to evaluate the "depth and duration of hepatitis B surface antigen decline," as reducing these antigens is widely believed to be a functional cure for hepatitis B.

Source: Duncan Hull via Flickr.

While the science behind its pipeline is certainly intriguing, the length of time it could take before investors see any tangible results is somewhat horrifying.

Even with Arrowhead shares well off their highs, the company's $588 million valuation is mind-boggling considering that half of its pipeline is preclinical in nature and the remaining half is either working through phase 1 studies, or, in the case of ARC-520, just beginning phase 2a studies. Remember that phase 1 is more or less a pharmacokinetic study stage whereby researchers are looking for a maximum-tolerated dose and laying out how safe and tolerable a prospective compound is. We won't get any tangible efficacy data to chew on until phase 2 trials. This means it could be years before Arrowhead's pipeline matures to the point where we can legitimately evaluate it enough to give it a $588 million valuation.

The good news is that Arrowhead has plenty of cash on hand ($160 million) and obvious collaborative potential. Still, I'm inclined to believe that short-sellers are wise to remain skeptical of Arrowhead's wet-behind-the-ears pipeline.

You're grounded
Last, but certainly not least, we have the recently merged American Airlines Group, which combined American Airlines and US Airways into one mega-airline.

On one hand, there's a lot to like here. A bigger airline with more hubs and greater clout will be able to negotiate with its suppliers more effectively. Furthermore, reducing overlapping expenses will save both companies millions of dollars, which should help offset rising jet fuel prices and help to even the playing field in a highly competitive sector. We've seen early evidence of these benefits, with American Airlines Group's EPS estimates for 2014 and 2015 rising better than 10% over the past three months.

However, there are also a number of reasons not to like this deal. Call me a traditionalist, but I prefer to invest in companies where customers stay loyal. US Airways and American Airlines consistently rank toward the bottom of most qualitative consumer satisfaction studies, which leads me to believe that if a better airline or offer ever comes along, these consumers will willingly jump ship.

Also, there's the ongoing concern of American Airlines Group's debt, even following its restructuring and current tight cost-control environment. The company is carrying a backbreaking $7.6 billion in net debt in a sector where capital investments are enormous, all in order to return mid-single-digit margins -- when it's lucky! It's an industry that investing greats like Warren Buffett have largely kept their nose clean of.

What we do know is that the airline industry is cyclical and that the airline sector has a difficult time when oil prices start rising rapidly. It's for this reason that I think the skeptics are right and shareholders should put on their parachutes and head for the emergency exits.