Over the past three weeks investors have been given a firsthand reminder that stocks can indeed go down as fast as they can go up. Following a voracious 11,800-point, six-year rally in the Dow Jones Industrial Average, the iconic index had given back more than 2,200 points through Friday from its all-time high set in May.
Though the correction in the Dow could represent an intriguing opportunity for long-term investors to go shopping and pick up some great companies at a discount compared to last month, it is also a time for skeptical investors to pounce on companies that could be showing signs of fundamental weakness. These skeptics are known as short-sellers.
To quickly summarize, a short-seller makes money when stock prices fall and loses money when they go up. It's a markedly riskier practice than simply buying and selling a stock -- a short-sellers' gains are capped at 100%, while their potential losses are technically limitless. Additionally, short-sellers are required to keep margin accounts with their brokers since they don't actually own stock in the company they're betting against, meaning they'll also be paying interest on the money they're using to keep their pessimistic bet open.
These Dow stocks have the most built-in pessimism
However, we wouldn't have a market without the ability of stocks to move up and down, meaning short-sellers have just as much of a chance of being right as the buy-and-hold investors.
With that in mind, let's briefly have a look at the Dow stocks that have attracted the highest levels of short interest as a percentage of float (i.e., freely tradable shares) and determine whether or not this pessimism is warranted.
Caterpillar (NYSE:CAT): 6.7% of shares held short as a percentage of float
Caterpillar, the heavy-duty machinery giant, is the Dow's most short-sold stock, with short-sellers holding the equivalent of 6.7% of its shares in their portfolios (this works out to about 40.3 million shares). For short-sellers, it's been a pretty good bet recently, with Caterpillar shares down more than a third since July 2014 and its shares doing next to nothing over the past decade.
But does a bet on additional downside make sense? Despite being the brand name in heavy construction, I'd be inclined to err on the side of caution, and perhaps even side with skeptics on Caterpillar.
Although the very long-term trend would suggest that growing demand for metals and coal and various construction projects around the globe should boost demand for Caterpillar's heavy-duty equipment, not even Caterpillar's management team can offer a near-term forecast with any confidence. There are just too many current uncertainties at the moment, including commodity price fluctuations, which can affect equipment demand if prices fall, a possible growth slowdown in China, and turmoil in the EU from Greece. The only tool at Caterpillar's disposal is cost-cutting, and that only takes a business so far. Caterpillar will need to see its sales stabilize for multiple quarters in a row if it hopes to shake short-sellers.
DuPont (NYSE:DD): 4.1% of shares held short as a percentage of float
Speaking of a stock that hasn't gone anywhere in a long time, chemicals giant DuPont perfectly fits the bill. DuPont, the Dow's second most short-sold stock, has seen its stock go absolutely nowhere over the last 18 years, not including dividends.
"What's wrong with DuPont?" you ask? The biggest hurdle for DuPont to overcome is that its business is highly cyclical. DuPont relies on global economic expansion to drive growth in its top- and bottom-line, as well as its pricing power. Aside from global economic growth, DuPont is left with minimal expansion pathways beyond going out and making a purchase.
On paper, DuPont looks like a great company to own long-term considering its ties to the agriculture industry and the need within the U.S. and around the globe to boost crop yields as the population increases. But what's on paper differs from what we've seen with DuPont's actual sales and EPS results. The chemicals business is highly competitive, the company could find itself (specifically its genetically modified organisms) tightly regulated in the future, and it's never found a way to avoid being heavily reliant on economic cycles. I suspect now could actually be a reasonable time to consider a bet against DuPont.
Disney (NYSE:DIS): 3.8% of shares held short as a percentage of float
Lastly, the House of Mouse has attracted the ire of pessimists following its nearly 20% plunge since the beginning of August.
The impetus for Disney's plunge is pretty simple: following a quadrupling in its share price since 2011, Disney fell short of Wall Street's lofty revenue expectations for the quarter, and it warned that profits for its cable operations may not be as robust as expected, with fewer subscribers now latching onto ESPN.
But should short-sellers take this earnings weakness as a sign to attack? I wouldn't be so fast to pull the trigger and bet against Disney. Even though its stock may have been priced at quite the premium, it also possesses incredible brand power that translates into big bucks. It has multi-generational appeal, its brand is widely recognized, it has exceptional pricing power at its theme parks, and the Disney brand is all about customer experiences. Though it can be a bit tough to quantify how much a brand with so many intangibles is worth, Disney's top-notch status in a number of respects makes it a company I wouldn't consider betting against.